Debt is Interesting

14,100,000,000,000.

That unfathomable number is 14.1 trillion, and it represents the total consumer debt owed by Americans as of 2019¹. To put that amount into perspective, imagine a pile of one million dollars. Now picture one million piles of that size. That’s 1/14 of America’s consumer debt, and it’s only getting larger.

What is Debt?#

Debt is simply borrowed money that has to be paid back to the lender at a later date. The total amount to be repaid will typically include the initial loan amount plus interest, or the cost of borrowing that money. The amount of interest owed depends on the initial loan amount, the length of time the loan takes to be repaid, and the rate at which the interest accrues (the interest rate). The interest owed grows as each of these factors increases, and vice versa.

A few common examples of debt include mortgages, student loans, car loans, credit card debt, cell phone payment plans, and large medical bills.

Put simply, all financial debt comes from borrowing money now to pay for something over time. That “something” can be a tangible asset like a car, a service such as physical therapy or a college class, or an investment such as a rental property.

Why is Debt Bad?#

Previously, we discussed the secret to building wealth is to spend less and invest the difference. By maximizing that available difference, one can allocate a larger amount of money toward investments, which has a drastic positive impact on the accumulation of wealth, especially in the early phases.

Every month, debt payments divert money away from that difference. Eliminating debt allows an individual to dramatically improve the efficiency with which they use their money.² It also affects the other side of the equation by reducing expenses; that same individual could survive longer on the same amount of money since they don’t have a steady flow of debt payments draining their savings.

How Do I Get Out of Debt?#

So what’s the most efficient way to pay off those loans and free up some monthly cash flow? There are a few popular methods of debt repayment that each have their own advantages and disadvantages.

The Snowball Method

The Snowball method is a very popular approach that provides people with early and frequent psychological benefits as each piece of debt is erased. The simple steps describing this method are as follows:

• Start by paying only the minimum required payments on all pieces of debt.
• Then put any spare money each month toward the loan with the smallest balance (meaning you’ll be paying the minimum required payment + any additional money you can throw at it).
• When the smallest loan is paid off, start the process over with the next smallest loan.

This approach is popular because paying off debt is extremely satisfying, and by attacking the smallest loan first, a person using this method gets to celebrate the accomplishment of erasing that loan earlier than they might with other methods.

Furthermore, once the smallest loan is paid off, the money that was required to go to that loan can now be used against the next smallest loan. Each time a piece of debt is paid off, more money is freed up for the next loan. It’s a snowball effect.

The drawback of this method is that, despite its simplicity and the encouraging emotional benefits, it’s almost never the optimal method. This approach will usually result in a person paying more in interest and paying off the entirety of their debt later than they would with the following method (unless the two methods coincidentally suggest that all loans be paid off in the same order).

The Avalanche Method

The Avalanche method is for those who value pure numbers and efficiency over emotional benefits while still eliminating uncertainty when it comes to debt repayment. As previously stated, while the Snowball method provides small, early victories that can reinforce a user’s progress, the Avalanche method ignores loan balances entirely and instead focuses on the interest rate of each piece of debt. The process is as follows:

• Start by paying only the minimum required payments on all pieces of debt.
• Then put any spare money each month toward the loan with the highest interest rate (meaning you’ll be paying the minimum required payment + any additional money you can throw at it).
• When the loan with the highest interest rate is paid off, start the process over with the loan with the next highest interest rate.

Higher interest rates mean that borrowing money is more expensive. For an example with back-of-the-envelope math: if Loans A and B both have a balance of $10,000 but Loan A has an interest rate of 10% and Loan B has an interest rate of 20%, Loan A would cost $1000 in interest per year while Loan B would cost $2000 in interest per year, despite them having the same initial balance.

In this example, each dollar in Loan A costs $1 x 10% = $0.10 per year, while each dollar in loan B costs $1 x 20% = $0.20 per year. Breaking the cost of borrowing down to a “per dollar” basis clearly exposes which loan is best wiped out first, regardless of the remaining balance. Therefore, putting as much money as possible toward Loan B while paying only the minimum required amount on Loan A (until B is paid off) will minimize the amount of interest paid over the length of the loans.

Both the Snowball and Avalanche methods have their upsides. But this is where the “personal” element of “personal finance” comes into play. It’s up to the individual to decide what’s more important to them: paying off small debts quickly and getting that psychological boost (Snowball) or paying off all debt in the shortest possible time frame (Avalanche).

Minimums and Invest the Difference

The third strategy to paying off debt doesn’t have a clever name, but that doesn’t mean it’s a bad approach. This strategy takes slightly more thought to implement, can change over time, and has some risk involved, but can often provide more long term upside than the other methods mentioned so far.

The basics of this strategy are outlined as follows:

• Start by paying only the minimum required payments on all pieces of debt.
• Evaluate the interest rates on each individual debt. Do you think that your money (if it were invested) could grow at a higher rate than the rate that your debt grows?
  • If yes, continue paying the minimums on your debts, and invest all leftover money.
  • If no, revert to the Avalanche method until the highest interest loan is paid off, then start this method over.

This method is a bit more complicated, so let’s look at a simple example. Let’s say a person has two loans, Loan A and Loan B. Loan A has an interest rate of 4% and Loan B has an interest rate of 3%. The S&P 500 has averaged between 7-10% growth per year over long periods of time.

The optimal choice for this person might be to continue only making the minimum payments on their two loans, which means paying 3 and 4% interest per year on the remaining balances, and then investing all extra money into an S&P 500 index fund. If they earn 8% per year on the invested money and continue paying 3-4% on their debt, they’re growing their overall wealth by 4-5% more per year than they would have if they had concentrated solely on paying off their debt.

Conversely, if a person has a loan with an interest rate of 20%, for example credit card debt, it would be very difficult to find an investment that one could confidently say could grow at a higher rate. In this instance, paying off the debt would usually be the better choice.

While this method typically results in debt hanging around significantly longer, it also frequently allows the individual to grow their investments while still having that debt, so when they do eventually become debt-free, they’re not starting their investment portfolio from scratch. In fact, in terms of net worth, they’re often ahead of those who aggressively focus on paying off debt.

This strategy sounds great, but what are the risks? Some things that could potentially derail an individual using this approach are:

• Subpar market returns. If the stock market happens to underperform during the lifespan of the debt, it could actually leave the individual in a worse position than if they had focused entirely on debt.
• Lack of discipline. This strategy is not a suggestion to pay only the minimums and splurge with any extra money. Doing that would only result in debt costing more than necessary and investment growth being stunted. The strategy only works if the money that isn’t being put toward debt is being invested into an asset that has a chance to grow at a higher rate than the debt.

Each debt payment is essentially equivalent to getting a guaranteed return on investment equal to the interest rate of the loan. For example, making payments on debt with a 4% interest rate has the same effect on one’s net worth as investing in an asset that grows by 4% each year. But rather than growing the value of your investments by that rate, you’re instead preventing the size of your debt from growing by that rate.

As such, once again the choice to utilize this strategy is personal. Even if the stock market has historically returned 7-10% per year, who’s to say that it doesn’t crash during the next four years while you pay off your car loan? Or maybe it grows at 15% per year over that span. Nobody knows. Do you want the guaranteed rate of return from paying off the debt, or the unknown, potentially larger return from an investment? It’s up to the individual to decide whether or not to take that risk.

Conclusion#

Debt is a concept that’s so familiar that it’s practically become a normal part of life. But it doesn’t have to be that way. By evaluating your current debts, choosing a strategy, and sticking to it, you can minimize the negative impact that debt has on your financial well-being.