Everybody knows having debt will consume a portion of your income each month until the debt gets paid off. Of course, once the debt is paid off your monthly cash flow surplus will increase, and with this surplus we can do some really exciting things to accelerate towards achieving your financial goals. But how should we pay off the debt? We want to be smart with our strategy, and there are a couple very intriguing debt payoff strategies in today’s market environment.
Debt Snowball
The debt snowball may be one of the most popular strategies for paying down debt. The basic idea is you continue making minimum payments on every piece of debt you have, but all excess cash flow each month gets used towards the debt with the lowest balance. Naturally, this will result in the lowest balance debt being paid off relatively quickly. Once it is paid off, you take the entire payment you were putting towards this debt, and pile it all onto the next lowest debt balance. This process continues over and over again until eventually you are debt free. On the final piece of debt you will have been paying a fairly large monthly payment, and this large monthly payment can now all be used towards putting yourself ahead. For example it could be used towards general savings, retirement savings, investments, etc. The general idea for this strategy is to stack up “wins” early on in the plan by fully paying off loans. This will create a sense of excitement towards debt payments and will drive you to continue paying down debt quickly.
Interest Snowball
The interest snowball is a very similar concept as the debt snowball, but it could make more sense for someone with a very analytical mindset. In this example you make all of the minimum payments again, but you take all excess cash flow and put it towards whichever piece of debt charges the highest interest rate. This strategy could take longer to fully pay off the first few pieces of debt because they could be large balances, but for someone who is always thinking of the most efficient use of your money this makes sense because you are eliminating larger interest amounts from accruing immediately. Just like in the snowball you continue piling monthly payments on top of each other as debts get paid off, and eventually all debt is paid off and we can do something with the monthly cash flow to put ourselves ahead.
Earn More Than the Interest
This final strategy is a very unique one, and it is only possible as a result of the historic interest rate environment we have found ourselves in over the last few years. If you took out a loan, or refinanced, during the last few years at the height of the Covid pandemic, you may have a very low interest rate. It is not uncommon to see loans from this time period with interest rates of 2.5-3.0%. In 2022, the interest rates have spiked due to the Federal Reserve’s rate hiking. Because of these hikes, money market rates are paying above 3.7% as of November, 2022. For people with an analytical mind who are always looking for the best opportunity, this is certainly exciting. Theoretically, someone with a low interest rate loan could simply park their monthly loan payments in a money market. Then they would collect the interest payment of above 3% annualized, and use it to pay down the debt. For example, if the debt charges 2.5%, and the money market pays 3%, then the person can pay off all of the interest plus another 0.5% due to the interest their money earned. This strategy of course results in the longest time taken to pay off all of the debt, but it is certainly an intriguing idea to consider. Additionally, this strategy may not be available for very long if interest rates were to decrease in the near future because this would cause money market rates to go down as well.
Conclusion
There are many good strategies for paying down debt. Taking the first step in talking with an advisor and coming up with a plan is the most important, because without a plan the odds of actually taking action decrease significantly. If you would like to discuss your debt payoff plan please give our office a call at (734) 681-7575 or email me at preston@peakwm.com.