Tackling Debt, pt 2

Last week in Tackling Debt, pt 1 we did a walk-through exercise using the Fundamental vs Significant distinction from 2 weeks ago in planning out an approach to Debt Management. We went through a brief exercise of the first 3 steps of the process. First, tracking our spending, then building out a budget, and finally getting into a stable place with it that reliably yields a good sum of “extra money” to dedicate each month to our Debt Management plan. We are now ready to begin Step 4 with our resulting extra $500 per month in hand per the example. Obviously this is a simplified scenario, but the general principles will hold true for any complex priority landscape. Again, fair warning that this example/topic is pretty specific, so get off the bus now if it’s not of particular interest to you.

 Bringing the Fundamental vs Significant lens to bear on things is where we begin this step as well. A distinction that most financial advisors would seek to clarify when looking at Debt Management is to separate out the “good debt” from the “bad debt.” In simple terms, “good debt” is the kind where your money is out there “working for you” with the idea being that these are things you owe money on that will build wealth, increase income, or otherwise improve your long term financial prospects. Student loans and mortgages are generally considered “good debt” for these reasons. “Bad debt,” on the other hand, is all the other types of debt that are incurred when purchasing rapidly depreciating assets or general consumption of nonessentials like fashion and entertainment. Auto loans are considered “bad debt” here as new cars considerably depreciate the very second you drive them off the lot. As are all other purchases like clothes, consumables, and home goods where you keep adding costs to the original purchase price through ongoing interest payments.

 This first pass in identifying the Fundamentals at this step has yielded the two categories of “good debt” and “bad debt.” Let’s move the “good debt” items off to the side and leave them there for now. “Bad debt” is our next focal point, so let’s again do a quick pass over this pile with our Fundamental lens to see how we can further parse them out. For this example we’ll imagine a simple scenario where there is a single car loan and 3 credit card accounts. The car loan is on fixed terms, both in amount due and payment schedule, and is on track to be paid off in less than a year. Let’s move that off the table and just focus on the 3 remaining credit card accounts as the Fundamentals we want to work with for now.

 Now we run a third pass for Fundamentals to set up our next step in the process. Simply write out the total amount due for each of these 3 accounts as well as the interest rate tied to them. Don’t worry about minimum payments or credit available or anything else for now, those aren’t critical to this process. Lay the 3 cards out in a row, left to right, with the highest interest rate card on the left and the lowest on the right. This is one roadmap for where to apply that extra $500 each month. From a strictly rational point of view you want to pay off the highest interest rate card first and then move on to the next highest and so forth as that “saves” you the most money over the timeline of paying all 3 of them down to zero. The math can get tricky to illustrate this point more clearly, so just trust me on this one here. But math and rationality are only part of the equation, and the smaller part for most people.

 Now is a good time to circle back to the Significant goal of “succeeding at this and feeling good about it” to see if how these credit card accounts stack up against each other from a feeling point of view. Do any of these cards represent or connect to purchases made that evoke negative feelings? Is there one card that was leaned on for more impulsive purchases with higher emotional energy, like expensive clothes that remain unworn on hangers in the closet with their tags still on them? If the cards are all seen equally then simply line keep them lined up as they are in the horizontal row based on interest rates. If they rank unequally from an emotional perspective, any emotional perspective, then let’s arrange them into a vertical column with the most negatively charged card at the top and least at the bottom.

A third approach is to line them up by balance size, smallest to largest. Paying them off in this order is referred to as the Debt Snowball and is a great way to build momentum by racking up some clear wins early in the process. Another benefit of this process is that the amount of money applied to each subsequent debt grows as the previous minimum payment amounts are freed up.

 From here the choice of “where to start?” has been greatly simplified, and mostly answered. You started by separating “good debt” from “bad debt”, and within the “bad debt” category you separated out the credit cards from the car loan. Now the final action plan can be determined by checking back in with your Significance goal of “succeeding at this and feeling really good.” Rest in the question for a few minutes. What feels “really good”? Paying off the highest interest card first knowing you are saving money in the long run, paying them off in the Debt Snowball method, or paying them off according to how you feel about the card and its charges? Which account’s rapidly shrinking balance brings the biggest smile to your face? Which card’s “New Balance =$0.00” brings up the emotional energy that fuels your motivational engine?

 This alignment between the Fundamental facts clearly considered and Significant emotion-based goals clearly articulated is a powerful engine for driving the change you want to see in your life. And most importantly, you’re in the driver’s seat making it happen through clear conjoining of intention and action. Your “bad debt” will slowly roll off your balance sheet as the months tick by, and eventually you’ll have the complex priority landscape in front of you that defines the “where do I invest?” space.

This new financial freedom creates its own set of problems, but I assure you they are much better ones to have than dreading your monthly credit card statements.