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A Rationale Behind Rational Debt Management

| April 05, 2019
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In our line of work, we run across people from different walks of life – those with annual expenses of $30,000 all the way to $3 million. We have found that irrespective of one’s income and lifestyle, debt management has a role to play, and how you manage that debt can make the difference in achieving your life goals, such as retiring early or paying for your children’s education.

In this article, we are going to discuss the key mental debt management mistake we all make as humans (so we can avoid it) and examine the process we utilize with our clients when considering the best course of action for paying down their debt.

Debt Management & Mental Accounting

Mental accounting is a key concept of behavioral finance that we have discussed in a past article, and it refers to the ways in which we mentally categorize assets, transactions, and other financial information in our brains. In theory, all of our resources should be fungible – dollars are dollars, regardless of what (liquid) account they’re in – but in practice, this is not how we typically behave. A study[1] by Abigail Sussman and Eldar Shafir explores one particular form of mental accounting – the ways we tend to categorize assets and debt based on our net worth. By presenting participants with financial profiles that were equivalent in net worth but varying in the structure of their balance sheets, the researchers found that people tend to prefer having more assets when net worth is negative, but less debt when net worth is positive.[2]

And this finding is notable, as it has several important implications from a financial planning perspective. For instance, it can help explain why people struggling with debt tend to accumulate assets and not pay down their debt, even if they’re keeping cash in a 0.35%-yield savings accounts while compounding 20% credit card interest rates. Additionally, this may be why affluent clients who can afford some level of healthy leverage still often want to pay down their mortgage. Ironically, this means that the people who can afford to “prudently” use leverage tend to eschew it, while those who can least afford leverage tend to engage in high-debt-profile behaviors that may actually amplify financial fragility. Furthermore, preferences seem to shift suddenly, particularly as households pay down debt and begin to move into positive net worth territory, which may (or may not) align with what they should actually be focusing on. And for those who enter positive net worth territory quickly, there may be an overemphasis on paying down debt relative quickly (now that they “can”), rather than saving into investment accounts which may grow at a higher rate in the long-run.

The Process We Follow

Below is the process we traditionally follow in our financial planning meetings with our clients. We say “traditionally” because every situation is different, and we may very well diverge from this process if the situation warrants – this is the fluid nature of our profession as we deal with different people in a variety of life circumstances. Thus, please understand that this is a high level, general process and may not necessarily apply to you.

  1. Create Your Personal Balance Sheet

The very first step in the process is to create a balance sheet with each of your assets and liability balances. On the asset side, we would include the type of account (checking, savings, traditional 401k, Roth IRA, etc.), and if you are somewhat savvy, the long term return for the type of account (depending on the allocation of each account, you can determine an approximate long term return based on history – note this is NOT guaranteed, but it is still helpful).

On the debt side, we recommend that next to the balance for each liability, you include the interest rate as well as the payment and if there is a balloon payment at some point in the future (I.E. if your mortgage is an ARM or you have rolled your credit card debt to a 0% interest card).  

This will provide you with a good understanding of the types of accounts/liabilities you have so you can better prioritize where to place your excess income.

  1. Make Sure You Have Enough Emergency Cash

Somewhat related to Step 1, before you have the urge to begin paying down debt immediately, you need to first make sure that you have some level of emergency cash. Now, this can be somewhat of a tight rope. If you do not have enough emergency cash, you can actually sink into an even greater hole if you have to miss work/lose your job or have a sudden large unexpected expense pop up. Thus, for those that do not have the bare minimum of emergency cash set aside, it is extremely important that you build this up first. For those that do have the bare minimum of emergency cash set aside, it doesn’t make sense to utilize this fund to pay down your debt either. This is similar to investing all of your money in a single stock – it can work out wonderfully if you hit a home run, but you are risking your entire future to do so, and we planners are always looking at ways to mitigate risk.

At the same time, if you keep too much cash on hand (more than the amount necessary for the emergency fund), this can be a poor decision as well. Cash (if in a checking or savings account) is earning next to nothing in the way of interest nowadays – long gone are the days where savings accounts were earning 5-8%. If you have debt with a high interest rate, you are essentially making a tradeoff of keeping an asset earning 0% interest for a liability that is earning a high negative interest rate.

For example, if you have cash over and above the amount needed for an emergency fund of $10,000, and you have debt of $10,000 with an interest rate of 10%, you are essentially “losing” $1,000 annually by not paying off this debt. But it is actually worse than that, as the minimum payment may not be enough to pay off the interest, and the principal on the debt could potentially be growing over time, compounding the problem further. Also, with a higher principal debt balance comes a higher interest rate, which can put more strain on your cash flow.

Thus, you have a bit of a tightrope to walk – you need to have some form of cash available for emergency purposes, but you do not want to have too much cash on hand which is better used to pay down your debts. The amount of cash you need to keep on hand really depends on the amount of total debt you have and the interest rates of such debt.

The rule of thumb is that you should have 3-6 months of your monthly expenses set aside for emergency purposes. However, this is in a perfect world – for most middle class earners with insurmountable, high interest rate debt, it could take years to save 6 months of their monthly expenses to cash, all the while their debt may be mushrooming, compounding the strain on their cash flow. Thus, the more debt you have and the higher the interest rate on such debt, there is a greater need to be more aggressive in paying it off, which means keeping a smaller emergency cash fund.

Although there is very little data on this topic, a survey[3]by Michelle Delgado of Clutch.com, a business to business HR firm, it takes, on average, 2 months to find a new job – although others have found that it takes even longer,[4] especially the more income you earn. Thus, we would recommend that, at a bare minimum, regardless of your debt position, you should have at least 2 months of expenses saved to emergency cash, and the more income you earn, the more you should have saved. This is absolutely critical before you even consider starting to pay off your debt.

  1. Prioritizing Debt Payoff

When you’ve reached a place where you have created your personal balance sheet and have the necessary emergency fund available, you can now begin prioritizing your debt. You should have the minimum/regular payments and interest rates on each piece of debt – you should write them down in order from highest to lowest interest rate.

You should make the minimum payments on all of your debts with the exception of the debt with the highest interest rate – this is the debt you need to focus on. You should make excess payments with your excess income towards this debt until it is fully paid off, then go right down the list to the next debt and do the same thing (throw as much of your excess income towards this debt, and so forth). The best way to do this is to set up auto payments – set your payment to automatically come out of your checking, since money you don’t see, you won’t spend.

When our clients have debts with high interest rates, we put all of our focus on trying pay down this debt instead of putting excess income into building assets. Sometimes, this even means reducing your contributions to retirement plans or making extra payments to your mortgage. It will not help to fund a retirement account that will earn 7-8% long term (plus the tax deferral benefits) when the clients have debt with double digit interest rates. If we do tell our clients to reduce their retirement plan contributions, we will typically fund enough to at least get an employer match (if there is one, as this is “free” money). The same goes for college 529 plan contributions – it may seem selfish, but we need our clients to focus on improving their own situation first, as no one is going to lend them money in retirement (their children will have the potential to take on student loans).

  1. Consider Debt Options for Credit Card Debt

If you have credit card debt, there are a myriad of options for helping pay down your principal, as opposed to simply paying off your credit cards by traditional means. This includes:

  1. Consolidation through a Personal Loan
  2. Low Interest/No Interest Credit Card Transfers
  3. Credit Counseling

Consolidation through a Personal Loan

The first option is to consider consolidating via a personal loan. There are debt consolidation options whereby you consolidate all of your credit card debt into a single loan with a single payment/single interest rate. There are several benefits of doing so. The first is easy to see – simplification. Instead of having several loan servicers, you are paying off a single loan, so there is less of a chance of missing a payment/less hassle overall. Second, some debt companies offer a simple interest rate – thus you do not have to worry about rate fluctuations which comes with some cards having a variable rate. They also typically offer a period certain for paying off the loan – you will thus have a definite plan for paying off your debt (I.E. you will know in 3-5 years that your debts will be paid off so long as you make payments). You should make sure to read the small print to understand the provisions, particularly whether there are any hidden fees for taking such a loan – these personal loans sometimes have loan origination fees and/or early repayment fees, so you should ask about these fees and any other additional fees. You should also make sure that the payment schedule is possible – the last thing you want to do is consolidate only to find that you cannot possibly make the payment. Note that you must have a decent credit score to qualify.

Low Interest/No Interest Credit Card Transfers

Next, you could consider moving a portion of your balance to a lower interest/0% interest credit card. There are many credit card companies that are hungry for other companies’ debts. In fact, some of the bigger credit card companies offer a 0% interest rate for transferring your debt to them for a certain period of time. This allows you to take aim at the principal, thus allowing you to pay down the debt dramatically faster. The main issue to be aware of is if you do not pay off your debt within the introductory 0% interest period (typically 18 months), not only will you be back to where you started (with a high interest rate), all of the accrued interest (the interest you would have paid but for the 0% introductory period) is owed immediately. Thus, you need to make sure to choose an amount to transfer that you can (conservatively) pay off within the necessary timeframe.

Credit Counseling

Lastly, there is credit counseling. Credit counseling organizations are typically non-profits who offer free services to help you with budgeting to pay down debt, reviewing and improving your credit history, and (if needed) providing a debt management plan (typically as a last resort, since there is a fee involved). 

Under a debt management plan, the credit counseling organization works with you and your creditors on developing a plan to pay down your debt. You deposit money with the credit counseling organization each month, and the organization uses your deposits to pay your creditors according to the plan devised by both you and your counselor. The amount you pay is tailored to what you can afford. Your counselor will provide the necessary coaching to keep you on track and more organized by ensuring you make your payments. Note, however, that many of these plans have a monthly fee, but the hope is that your counselor provides enough value to overcome this fee.

Lastly, having a financial planner can help – there are many areas outside of managing debt which need to be addressed, and a good financial planner can help with both debt management AND managing these other areas (risk management, estate/tax planning, investments, etc.). If you need help with managing your debt, we are happy to help – feel free to reach out to either of us!

[1] Abigail Sussman and Eldar Shafir: On Assets and Debt in the Psychology of Perceived Wealth

[2] For instance, despite the fact that net worth is actually the same -$100,000 in both scenarios, households tend to indicate a preference for having $100,000 in assets and $200,000 in debt over just $10,000 in assets and $110,000 in debt. However, if the assets and liabilities in the scenario above were reversed (i.e., net worth was positive $100,000 instead), then households would tend to prefer simply paying down their debt (even if it means having less in liquid assets).

[3] Michelle Delgado of Clutch.com: Statistics on the Average Job Search in 2018

[4] Alison Doyle of The Balance Careers: How Long Does it Take to Find a Job?

Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors Corp.

Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor.  Insurance offered through Lincoln affiliates and other fine companies. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors Corp.

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