Key Takeaways:
- Living within your means is a prerequisite to being able to pay down debt
- Tackling small debts first can establish confidence quickly
- Prioritizing highest interest debt is optimal – ONLY IF you stick with it
In our first Atheneum article on debt, Brian discussed the difference between good and bad debts. He defined good debts as those that will appreciate or help grow your net worth over time, such as mortgage, education, and business investment. This is great advice for anyone considering taking on new debt. Unfortunately, we don’t often get a chance to give our input before someone takes out a loan or swipes the credit card. Today we discuss our ideas on what to do after you’ve already accrued good or bad debt.
Paying down debt is a lot like losing weight. It doesn’t matter how many miles you run if you’re eating cheeseburgers every day. You have to address the root cause to make any progress, which means focusing on your diet. First you must eat a reasonable amount, and then additional exercise can accelerate your progress. With debt, your daily diet is your budget. There’s simply no way to pay down debt if you are living beyond your means by spending more than you bring in as income. This has to be step one in prioritizing debt payoff: dollars in > dollars out.
Once you have your budget balanced, we can address how to best exercise off that excess debt. Where should debt payoff reside in your ranking of household priorities? This is a personal decision, but there are a few items we believe supersede debt payoff. Health insurance comes first because without it, you are exposed to substantial new debts if you have a health problem. An emergency fund gives the same protection against new debts in case of accidents or property damage. Finally, a company retirement plan match is a rare instance of an opportunity for free money and should be utilized before increasing debt payments. Ideally these items are worked into the budget before we can finally tackle how to prioritize debts.
After tackling these basics, it’s time to pay down debt with your excess cash flow. There are two schools of thought on prioritizing different debts. The first is the snowball method, popularized by Dave Ramsey. He says you should pay off your smallest debts first so that you make progress by eliminating individual debts, which helps your financial confidence grow like a snowball rolling down a hill. This strategy makes sense for households new to budgeting or people who emotionally benefit from experiencing achieved success. Just like in our weight loss analogy, these small, short-term wins motivate you to continue your progress. It’s hard to argue against this logic as Dave Ramsey has documented thousands of families becoming debt free with this method.
Nonetheless, there is an alternative method that seeks to maximize your financial well-being. It is often referred to as the avalanche method to provide contrast to the snowball method. This strategy prioritizes paying off the highest interest debts first in order to minimize the total interest paid. It will maximize your household net worth if you stick to the plan, but the progress is less tangible and immediately gratifying. Since either method requires steady commitment to become debt-free, we prefer you choose the one that best matches your family’s personality as it will give you the best odds of success.
