Financial Literacy

The Fastest Way To Pay Down Debt

If you have several outstanding loans, what’s the fastest way to pay them down? How should you prioritize which loan to pay down first?

The most efficient way to pay down existing debt burden is better known as the debt avalanche method.

It goes like this:

  1. Make an inventory of all the debt you have and their associated interest rate.
  2. Keep paying the minimum payment on all debt to avoid any fees and deteriorate your credit score.
  3. Focus on one loan at a time and make an extra payment on the loan that has the highest interest rate. Keep doing it until the loan is paid.
  4. Congratulations, you now have one loan paid off. Move to the next highest interest rate loan and use the extra cash freed from the minimum payment of the loan you just paid to pay this second loan even faster.
  5. Rinse, repeat, until you do not have any more outstanding debt, paying each loan faster by redirecting the extra cash from each paid off loan towards paying the next one.

This strategy minimizes the amount of interest you pay by targeting the loans with the highest interest rates first.

Some argue that in the battle towards paying off debt, the psychological aspect may be more important as it is often a marathon more than a sprint. And therefore seeking early sign of encouragement may go a long way to stay on the path of debt freedom.

In that regards the debt snowball approach is sometimes considered. The principle is similar to the debt avalanche method but instead of focusing on the loan with the highest interest rate, you’d focus on the loan with the smallest balance. So you more quickly scratch a loan off your list as an early encouragement.

However Mr. Honu is way too cartesian to allow extra interest payment to run and would focus on the debt avalanche method instead. But that’s just me. The debt snowball can be a decent alternative and is certainly better than letting your debt run away.

There are more resources on the debt avalanche and the debt snowball on the internet.

Financial Literacy

Is Debt Bad and Should It Be Avoided at All Costs?

If you have some debt, should you pay it first or should you try to invest your way out of it? Is debt good or bad?

Generally speaking and as noticed in the “defining asset vs liability” post, debt is not inherently good or bad, it’s mostly about how it’s used. At the end of the day, debt is just leverage and you pay a premium to use that leverage in the form of interests.

Therefore, from an economic perspective, it usually only makes sense to use this leverage if the benefit of this leverage outweighs the cost of the premium. More simply said, if you borrow money at 5% per year and you’re pretty sure you’ll make a 10% or 20% return on that borrowed money it’s certainly worth it. However if the returns were only 3%, the cost of the debt would be higher than what you’d earn and it would probably not make sense from an economic standpoint to contract such loan.

So in the end, using debt to acquire cash flow performing assets is definitely worth it if the returns are higher than the cost of servicing the debt. But otherwise it should be avoided. Using debt for regular consumption is probably the worse type of debt one can contract, since the returns on consumption items are usually 0%: that new appliance or that fancy dinner will not make you any money.

A note on education: the current outstanding student loan debt in the US is now over $1.6 trillion. And many people are stuck in a job that does not allow them to service their student debt burden. Worse, as of January 2020, student debt is not dischargeable in bankruptcy and you may be stuck with your student debt for life. So for any student looking for a student loan, it’s probably wise to check what’s the salary one can expect out of college to assess how much debt is reasonable.

There are several websites to check how much one can expect for a given job:

Having, let’s say, $50,000 of debt out of Med school to be a physician is probably reasonable, ditto with a Computer Science degree to be employed as a software engineer (at least in early 2020), as these jobs tend to earn at least six figures out of college, but it is not the case for many other degrees.

It may all sounds like common sense, but it’s important to absorb and never forget the fundamental economic mechanics of debt, because it’s easy to get tempted by a fancy new appliance, house or college degree that could put an enormous drag on your finances and delay your financial freedom by several years if not forever.

But what if you already have debt? Should you pay it first or invest your way out of it? Well, every investment carries some risk and the money invested can be completely lost. On the other hand, the debt you pay down, is a guaranteed balance payment you won’t have to service anymore. Therefore, it’s usually more advantageous to pay down existing consumer/student loan debt.

But debt at the end of the day is leverage, and leverage carries risk. And carrying risk over an extended period of time is something to be dealt with carefully.

So, how should you go about paying it off? Have a look at the Fastest Way To Pay Down Debt.