Paying Off Debt the Right Way
If you just graduated college, you may be suffering under the weight of some student loans, or at least know a whole bunch of people who are. You’re in good company, some 44 million people in the U.S. now have some form of student debt. Student loans in the U.S. reached $1.4 trillion dollars this year, nearly double the amount of outstanding credit card debt.
If you’re anywhere near the average, that means you’ve got around $32,000 in loans and an average monthly payment of around $350.
So, what to do? Obviously, you have to pay it off, but how and how quickly? We’ll explore the factors you should consider.
The debt avalanche is the fastest way to pay off debt
The fastest way to pay off debt is using the “debt avalanche”, which we describe in another article in greater detail. In a nutshell, you make minimum payments on all of your debt accounts and pour all of your extra money into paying off the debt with the highest interest rate. When that is done, you move onto the next highest rate and so on. This is mathematically the fastest, cheapest way to pay off debt.
But not necessarily the best…
Paying off debt the fastest, cheapest way ignores two important issues: your personal liquidity and the most efficient way to grow your net worth. Your personal liquidity is critical. If you put all available resources towards paying off debt, you won’t be saving anywhere else, meaning if you lose your job, or get sick, or your car breaks down, you’re one missed payment away from default. That’s too risky of an approach to be sensible. So, you’re not going to use all of your available cash flow to paying down debt. Besides, while paying off debt increases your net worth, never seeing the positive side of your balance sheet go up can be discouraging.
Another important factor is that you have options of where to put your money every month. Paying off debt may be the best option, but it may not be. The goal is the maximum growth of your net worth. If you have a 401k plan at work, particularly with an employer match, this is likely a more profitable option over the long run. So keep those things in mind as we go through our steps.
Go lower and go longer.
If your credit score is 680 or better, or you have someone to cosign for a loan, you may be able to refinance. As you might guess the rule of thumb here is if you can get a lower rate for the same term, or the same rate for a longer-term, do it. Aside from lowering your monthly payment, lengthening the term takes advantage of inflation. If you make $2,000 per month and your debt payment is $350 per month, then your payment is 17.5% of your income. At 2.5% inflation, in 10 years, you’ll be making $2,560, and your payment will now be 14% of your income. After 20 year is will be 11% of your income, so it will get a bit easier to pay off every year, even with the cost of other things going up. If you have an option to refinance over a longer period, but at a higher rate, use our mortgage calculator (for fixed-rate loans) to figure out if there is truly an economic benefit.
2) Figure out your budget.
In a perfect world, a person could say, “I want to pay off my student loans in 5 years”, figure out the monthly payment to accomplish that and be done with it. In a perfect world, however, no one would have student loans in the first place, so for most people, this approach isn’t feasible.
Instead, what you need to do is figure out what your minimum payments are, which you have to make, and then figure out how much additional money you can allocate every month or your various financial goals. Let’s say your minimum payments are $350 / month and you think you can allocate an additional $200 / month to achieving your financial goals, this $550 / month will all be contributing to increasing your net worth.
3) Figure out how much savings you need.
Start with 3 months of expenses as a safety net. Chances are, you’ll end up with a bit of money in other places, so this should buy you adequate time to rearrange things if the need arises. The easiest way to do this is to take you monthly after-tax earnings and subtract the extra amount you save. So in our example, with $2,000 of take home pay and $200 of extra savings, 3 months of savings would be ($2,000 – $200) x 3 = $5,400. You’re going to allocate money to savings every month until you reach this amount.
4) Allocate your extra.
You’re going to make your minimum payments, then decide where to put the excess. You want to allocate the money where it’s going to increase your net worth the most while maintaining your personal liquidity. So allocate part of the money to your savings account, and the rest to your other options. The percentage is up to you, but pick somewhere between 20% and 50% for savings until you reach your target and the rest to your other options. In our example, we had $200 extra, so we’ll put $100 in savings, meaning it will take around 4.5 years to reach our savings target, which of course will gradually adjust based on income, spending, job, living situation, etc. The other $100 should be allocated to the place that has the most economic benefit. Here’s an easy way to think about it. Pay debt with over 10% rates first, using up all the remaining monthly money. Once that is paid off, then put money in 401k up to the match amount. Then debt above 6%. Then 401k after your match account. Then any other debt at with an interest rate lower than 6%.
WeVest can help.
As you make your payments each month, balances will build, accounts will pay off, minimum payments will change, so it’s important to track and re-evaluate. WeVest makes it easy by prioritizing your payments based on maximizing your net worth growth, optimizing debt reduction, and re-projecting your future every step of the way. Click here for a free trial.