Bills, bills, so many to pay and so little money to work with…. what’s a person to do?
Let’s talk about some techniques used to pay down debt faster and enable more efficient use of money. A couple are popular and have been talked about by a plethora of people. Another is relatively new, and I think is definitely worth mentioning.
Snowball Method
The snowball method is a method of dent payment in which a person lists all their debts from smallest to largest dollar amount. Any extra money is devoted to paying off the smallest debt first while making the minimum monthly payments on other debts.
After the smallest debt is paid off, this payment money plus the extra money used to pay down debt is added to the next smallest amount until paid off. This continues until all the debts have been paid off.
This method has been popularized by Dave Ramsey who is a host of a popular personal finance advice radio show and best-selling author. The argument he uses for applying this method over the debt avalanche method (which we will discuss next) is the psychological benefits. The faster gratification received from paying off smaller debts will keep a person motivated towards paying off the larger ones (faster “wins” = greater chance of success).
Here’s an example of how this method works:
Let’s say you can afford to put $1,500 every month toward paying off your three sources of debt: $3,000 worth of credit card debt (with a minimum monthly payment of $120), $7,000 worth of auto loan debt (with a minimum monthly payment of $400), and a $35,000 student loan (with a minimum monthly payment of $600). Using the snowball method of debt repayment, you would spend a total of $1120 to cover each debt’s minimum monthly payment. You would then put the remaining $380 toward the credit card debt because it is the smallest of the three debts.
Once the credit card debt has been completely paid off, the extra payment will go toward retiring the second-largest debt, the auto loan. At that point, you will be spending $1000 a month on minimum monthly payments and have $500 extra to put towards the auto loan each month. Once the auto loan is paid off, all $1,500 will go toward the student loan until it, too, is paid in full and you are debt-free. Like a snowball, each paid-off debt frees more cash to go toward eliminating the remaining ones.
Avalanche Method
The debt avalanche allocates enough money to make the minimum payment on each source of debt, then devotes any remaining repayment funds to the debt with the highest interest rate. Using the debt avalanche approach, once the debt with the highest interest rate is entirely paid off, then the extra repayment funds go toward the next-highest interest-bearing loan. This system continues until all the debts are paid off.
The advantage of the debt avalanche method of debt repayment is that it minimizes the amount of interest paid while working toward your goal so long as you stick to the plan. It also lessens the amount of time it takes to get out of debt because less interest accumulates.
Interest adds to these debts because lenders use compound interest rates for calculating payments. Loans use interest which can compound daily, monthly, semi-annually, or annually.
The disadvantage of this technique is that it takes discipline and commitment to pull off. Even with the best intentions of sticking with the debt-avalanche system, it is easy to revert to making minimum payments on all the debts, especially after you experience unforeseen expenses like auto or home repairs.
Therefore, experts recommend that people should have but are not required to have at least 6 months of livings expenses set aside before undertaking this method in order to optimize success.
Here’s an example of how this method works:
Let’s say you have $1000 available every month, after living expenses, to put toward paying down your debt. Your current loans include:
- $15,000 on a credit card with a 18% APR (Annual Percentage Rate)
- $22,500 monthly car payment at a 6% interest rate
- $10,000 student loan payment with a 4% interest rate
For simplicity’s sake, and to take the payment amount out of the selection equation, assume each debt has a minimum monthly payment of $200.
You would need to allot $600 toward paying each loan’s minimum monthly payment ($200 x 3). The remaining $400 would be added to the money devoted to your highest-interest debt. In this example, you’d pay $600 ($200 + $400) toward settling the credit card debt with the 18% interest rate. Once the credit card is paid off, the extra funds would go toward retiring the second-highest interest-bearing debt, the car loan. All $800 ($200 + $200 + $400) would go to the debt with the next highest rate of interest, the car loan. Once this is paid off, the entire $1000 is then allocated towards paying off the student loan.
Cashflow Index Method (CFI)
A relatively new method for accelerated debt repayment and optimizing cashflow was created by Garret Gunderson from the Wealth Factory and is called the cashflow index (CFI) method. As I spoke about in a previous article, the technique labels expenses into 4 categories (productive, lifestyle, protective, and destructive). Then the cashflow index identifies the order to pay down your destructive expenses 1st followed by other applicable expenses (i.e. student loans, HELOC’s, etc. depending on how expenses are categorized).
Here’s how it works:
Take the balance of each loan and divide it by the minimum monthly payment. The higher the number, the more efficient the loan is. The lower the number the less efficient the loan is.
Cash Flow Index = Total Loan Amount / Minimum Monthly Payment
Whichever loan has the lowest CFI number is to be paid off first followed by the loan with the next lowest CFI number, etc. until all the loans are paid off. By paying off the inefficient loans first, cash flow is freed up to work on paying off the other debts faster.
From the article, here is the example I used:
Credit Card:
Balance: $20,000
Interest: 15%
Minimum Monthly Payment: $300
CFI: 67
Car Loan:
Balance: $20,000
Interest: 8%
Minimum Monthly Payment: $500
CFI: 40
Home Loan:
Balance: $100,000
Interest: 4.5%
Minimum Monthly Payment: $1000
CFI: 100
Personal Loan:
Balance: $15,000
Interest: 3%
Minimum Monthly Payment: $100
CFI: 150
Using CFI, the loan payoff should be paid off in the following order:
- Auto Loan
- Credit Card
- Home Loan
- Personal Loan
I like this method because CFI not only considers the monthly payment, but also indirectly the interest rate and cashflow optimization. The minimum monthly payment is set by considering payoff amount, interest rate, and term length. By dividing against the loan amount, it tells me which loans is the most inefficient using interest rate and loan terms as the prevailing criteria. In other words, it tells me where I get “the most bang for my buck”. This optimizes how I spend my money (cashflow) as well as the fastest way to reduce overall debt.
I also like this method because I can automate it. I can set it and forget it. It can also adjustable. As loan terms change over the life of the loan, the CFI may also change. I do annual re-calculations to ensure I am optimizing the order I payoff debt.
CFI also can spot inefficient loans and loans that may be candidates for restructuring. Here is how:
CFI < 50 à payoff 1st. Loan is inefficient
CFI between 50-100 à Candidates for loans restructuring. Frees up cash and can make more efficient
CFI > 100 à Loan is efficient
You can also use my free budgeting tool located here that automatically calculates CFI for each expense. It takes a little initial work to setup the budgeting tool, but it pays off the more you use it.
If I Had To Do It Over Again
Looking back on what I know now (hindsight is ALWAYS 20/20 😊) and could do it over again, here is what I would have done.
First off, I would have paid myself first. I have learned that you need to ALWAYS PAY YOURSELF FIRST. At the least, I would have put enough away in my 401K to meet the employer match.
Ideally, I would have maxed out my 401K PLUS maxed out a Roth IRA. If I did not have enough, I would have found a way. My job at the time paid overtime so that is a possibility. Another possibility is to start a side hustle (or two) to make this happen. I lost a lot of retirement money early on in my career by not doing this and I kick myself today for not doing it.
Next, I would have delayed debt reduction and saved enough of an emergency fund to have at least 1 month of living expenses covered within 1st 6 months of my career and then at least 3 months of living expenses saved by the end of my 2nd year of my career. I luckily had levers I could have pulled early in my career but looking back, the financial relief and breathing room created by having a solid emergency fund would have really helped me instead. I was playing with fire and luckily, I didn’t get burned (whew!).
Once I had a solid financial foundation, I would have created an income statement (i.e. fancy name for a budget) listing both income and expenses. Using this as my foundation, I would have found not only my discretionary income but also all my money leaks and plugged them to free up additional cash.
For example, I consistently received several thousand dollars a year on my tax return. Instead of giving the government an interest-free loan, could have used that cash real-time to payoff debt and fund retirement.
Next, I would have used the Cashflow Index Method to identify my destructive expenses and force rank the debt. This would have showed me how any extra money was going to payoff a debt first as well as identify candidates for loan restructuring. Any optimized cashflow would have been fed back into the destructive expenses to payoff debt as fast as possible AND continue building up the emergency fund (50/50 ratio between debt reduction and emergency fund building).
Looking back, my “entertainment” budget would not have been anywhere near as high as it was and that would have been ok. I would have found more creative ways to keep having fun and still work within my budget. As they say….. necessity is the mother of invention! 😊
There you have it. What I would have done if I could go back in time and kick my younger self in a$ and tell him what to do
What Should I Do?
This may be the question you are asking yourself now. The problem for many people is that their debt is so large and significant compared to their monthly income that it is overwhelming and will take many years to pay the balance down to zero. While it might be tempting to simply postpone saving while you’re paying off debts, that isn’t a realistic option. Even people with high debt have dreams and hopes for the future. They may want to get married, be able to purchase a home, start a family, or provide support for ailing loved ones — and that requires substantial savings.
Over the years, I have learned that the trick to success is to find a balance that works for your unique situation. No 2 people are alike, and no 2 situations are alike either. The most important thing to remember is to develop a plan that meet individual needs and stick to it.
I have given you a few tricks and techniques today that are easy to apply and take a small amount of discipline to enable. Stick to it. Don’t give up. If you want it, make it happen and don’t let anything stand in your way…… after all it’s YOUR life we are talking about! 😊
Live the Life You Want, Love, and Deserve! 😊