In our series: Debt and the Business Owner, we have come to the “HOW”…how to get out of debt. But where do you start? We’ll explain a few different methods to help you determine YOUR answer. You will need to pick one based on your specific situation. By the end of this article, you should have a pretty good idea of which debt reduction strategy is right for you.
You may be most familiar with this first method of how to get out for debt—the Debt Snowball Method. This method is most often linked to financial pundit Dave Ramsey. Although the Debt Snowball has a long history, Dave has driven the popularity of the Snowball method up.
The debt snowball method is quite simple. You attack your financial obligations by paying the minimum on everything except the debt with the smallest balance. Once you identify the debt with the smallest balance, you will pay the minimum payment AND any extra money toward the principle of this small debt.
Here’s a quick, simple example to explain the debt snowball. Let’s assume you have a $5,000 car note with a 4.5% interest rate, a $10,000 student loan with a 4.3% interest rate, and a $20,000 balance on your credit card with a 14% interest rate. Let’s also assume you have an extra $1000 a month that you want to use to eliminate your debt.
If you use the debt snowball method, you apply the extra $1,000 per month to the car since your car loan has the lowest balance in the example above. The debt snowball method doesn’t take the interest rates into account. You are merely focused on the debt with the lowest balance regardless of any other factors.
The theory behind choosing to pay the smallest amount off first is that you should experience a debt elimination victory very quickly. Once you have experienced the reward of reducing one debt, the hope is you will be even more motivated and prepared to attack the larger debt once you get to it.
Let’s go back to our example. After paying off the car debt, you would then take your extra $1,000 per month along with the payment you were making toward the car and combine it with the minimum payment toward your next lowest balance debt. Which in the example, the $10,000 student loan would be the next debt you tackle. Thus, you are paying the extra $1,000, the old car payment, AND the current student loan payment every month in one big debt busting payment toward the student loan balance. Now, the snowball is really moving, and when the student loan is paid, you repeat the process with the credit card bill until you knock it out and are completely debt free.
The debt snowball is a great strategy for those who like to see progress quickly. And since debt is one of the leading causes of stress, the physiological and psychological factors could be a much greater motivator. In fact, according to the Harvard Business Review, the debt snowball method kept consumers motivated more than other methods. Those utilizing this method tended to pay their debts off 15% faster than those paying equal sums.
Now, let’s look at method number two for getting out from under those obligations, the Debt Avalanche method. This method takes a completely different approach. Instead of focusing on the psychology of debt reduction, the Debt Avalanche takes a more analytical approach. It focuses on strictly the math.
For instance, using the exact same numbers as before—a $5,000 car note with a 4.5% interest rate, a $10,000 student loan with a 4.3% interest rate, and a $20,000 credit card balance that has a 14% rate. However, this time instead of focusing on paying off the smallest debt, the Debt Avalanche method factors the interest rate into the equation—which means if you use this approach you are focusing on paying your extra money on the massive credit card debt first.
While it will take longer to begin seeing results, you will be able to save money in the long run by eliminating the highest interest rate first. Here’s a breakdown of just how much when we compare the two side by side:
Thus in our circumstance, the Debt Avalanche would save us $297.00 in interest. You can see mathematically it makes the most sense to pay off your higher interest debts first. You end up paying less over the long run, because you may owe less in interest. While it didn’t happen with our example, many times, depending on your specific debt mix, you can actually reduce the total number of monthly payments you would make with the Debt Avalanche method.
However, remember the Harvard Business study? The fact is that some people need the motivation of meeting the smaller milestones to feel as though their plan is working. How about you? Implementing the Debt Avalanche takes a great deal of discipline. You will not see results quickly; however, your hard work will pay off in the end. Then again, perhaps emotionally shouldering the debt is more than you can handle and the math doesn’t matter to you. In that case, you should definitely consider the snowball method.
Now, that you understand the two most commonly used methods for reducing your financial obligations, I’m going to discuss a third, business-friendly tactic you can utilize.
Another strategy you can employ is what we call the Strategic Debt Pay Down method. I describe this Strategic method as prioritizing the order in which you apply extra money to your debts based on variables other than balance or interest. You are basically choosing to pay your debts off in an order that may not align with the standard Snowball or Avalanche method. And quite honestly, there are times when carrying debt might make more sense for business owners than paying it off, at least mathematically.
For example, let’s start with the number one debt I insist EVERY. SINGLE. PERSON. Pay off IMMEDIATELY. I’m talking, DO NOT PASS GO. DO NOT COLLECT $200. The ugliest debt of all. What exactly is that? The IRS!!
Look if you owe Uncle Sam, that’s not cool! He can seize your assets. Take away your passport! DO NOT, I repeat DO NOT, owe the government. I don’t care what you have to do to get this debt paid—I’m talking beg, borrow, refinance, or sell everything you own—just get it paid off now! If it’s a large amount, then you can enter into a payment arrangement. The IRS will often give you 72 months to pay the amount you owe. However, keep in mind that they may you charge interest and penalties. Speak with your tax advisor to see if you can’t reduce the amounts you owe in the future so that your bill doesn’t keep rising and guide you on the best way to pay them. So, if the three letters, I-R-S are on your liabilities sheet—put the number one beside it and knock it out ASAP!
Now, I’m hoping that debt did not appear on your list and we can start to look at the strategy that will help your business and personal finances begin to achieve all your dreams.
The next debt which should appear near the top of your priorities is consumer debt that requires no collateral. Basically, you are looking at things like credit cards, department store debt, personal loans, student loans, and sometimes car loans. These are debts that you cannot sell a specific asset to cover the liability. And now, you may be scratching your head saying, “Justin, I get credit cards and student loans, but a car loan. I can sell my car and pay off the debt.”
True, that may or may not be the case. All too often I see people who are so upside down on their car notes that if they sold their cars, they would still owe money! There will be times when you may not pay the car loan off as aggressively as another debt. For the most part, your car needs to be near the top of your liabilities sheet for strategic purposes. However, I do want to note that loans for autos that are used for in your business ( i.e., a fleet of vans to haul cargo) will follow a completely different set of guidelines.
Credit card debt, though, is one debt I hate! Hands down this particular debt used to keep me up at night. You want to aggressively knock this debt out. Nothing, and I do mean NOTHING, can deter your financial plans faster than credit card debt. If you can’t pay the balance off every month, you are giving your money away. The average interest rate on credit cards is 14.99%! Do you a realize how much money that is?
For example, we will make the assumption that you have a credit card balance of about $10,000. And your credit card is charging you the average interest rate charged by credit card companies (14,99%). Your monthly minimum payment would be roughly $400, and it would take you just over 12 years to pay off the credit card. And if this isn’t bad enough, the interest you would pay the credit card company is almost $4,500.00 over the life of the balance.
Friends, that is a ton of money. You could buy yourself a new four-wheeler, even take a nice vacation, or better yet, you could invest this money back into your business or retirement plans to help you reach your long-term goals. And it’s not just about the money! Credit cards companies are ruthless! So if credit card debt appears on your liabilities sheet, let’s get rid of it.
From this point forward we are going to start breaking down various scenarios that could pertain to your situation. So as we work these examples, understand each before numbering your liabilities.
Let’s start with student loans. For the majority of people, this loan should be near the top of your list. However, if you are a business owner facing significant tax burdens and have business debt, you may want to push the business debt in front of the student loan debt. Also, if you are working in a debt forgiveness position, you may want to place other debts above this one. Additionally, if you are in a high-risk job which could lead to a disability, delay accelerating the payoff of this type of debt, as it could be forgiven and wiped away in such circumstances.
Now let’s discuss lines of credit. For most business owners, lines of credits help us make strategic moves in our businesses. However, we must be cautious about how we utilize tools like these. If you have a line of credit, you should probably place this debt near the top of your priority list. Many times, lines of credits are not secured by an asset that can easily be sold to pay off the debt. So place this one near the top as well.
I mentioned car loans being near the top earlier and for good reason—cars depreciate in value. Car loans are actually one loan that I typically refuse to use. Remember though, it may be possible for you to sell the car to pay off the debt or at least most of it. So for that reason, I place car loans below student loans and lines of credit. However, that is dependent upon, the debt owed on the automobile being lower than the market price of the car.
Next, let’s talk business loans. Your business loan may be preventing you from utilizing tax planning to the fullest potential. So, if you are a business owner, speak with your CFP® and CPA about how quickly you need to pay this debt down for tax purposes. If that is the case, by eradicating the business loan, you could not only remove the debt and interest but could also end up saving money on your taxes. Should your financial advisors confirm that the business loan is hindering you, place this debt near the top. However, if your advisors say the loan is not hurting you, I would prioritize other debts, like those above, which could strategically benefit you greater in the long run.
Perhaps the largest debt for most Americans is the mortgage. I personally believe this should be the last debt any of us tackle. I often advise placing any debt secured by real estate at the bottom of your list. Don’t worry about this debt. Hold it till the very last.
Now, I’ve given you the information to understand your complete debt picture, which is essential to manage your debt productively. However, the ‘why’, the ‘what’, and the ‘how’ really isn’t the biggest factor in eliminating your debt. Friends, the single largest factor in destroying your debts is YOU! Everything hinges on what YOU do from this point forward. Knowledge alone will not get you out of debt, but action will. So ACT NOW! Choose a method and go! Start reducing your debts—both business and personal—to make your life Financially Simple™.