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Debt management: snowflakes, snowballs, and avalanches, oh my!

(I'm writing this in Texas in July, so yes, I'm aware of the irony!)

Whether you're drowning in student loan debt or just pondering whether to finish paying off your house, most folks these days have to address the issue of debt. While debt's not a bad thing in and of itself, there are a few issues that can make it a knotty problem.

For one, debt is like fast food, television, and Facebook: by going directly to the parts of our brains that crave short-term pleasure over long-term gain, debt can act like an addiction. We self-sabotage in the name of "consume now, pay later", applying all sorts of cognitive bias and self-delusion to justify decisions that a purely rational brain would throw out as lunacy. ("I lost five pounds, so I deserve a shopping spree on the credit card!" How is increasing your debt a moral issue?)

For another, there is a lot of money to be made in lending. The financial services industry exists to make a profit, and 18% credit card interest is a drool-worthy deal for them! They have absolutely zero incentive to help you pay off your debt -- and every incentive to do otherwise.

Put the two together, and you have a system that's pretty neatly stacked against the consumer. When large corporations can increase profits by playing your neurology against you, they get very, very good at it.

But wait, there's more! Debt also works the other way: for some of you, it's an invisible pressure, a weight on your shoulders. It doesn't matter what the interest rate is or how it fits into your short-term flexibility or long-term plans -- what bothers you is that payment going out every month. And there are often times when paying off your (low-interest, low-payment) debt early can decrease your Monte Carlo success rate!

I say all of this is drive home a very important point: debt is as much about emotion as it is about numbers. This is true about a lot of personal finance, but debt seems be a particularly common trap. It can be especially tricky if you're an engineer who prides yourself on your rationality -- and ignores your own cognitive bias!

Got it? Good. Now, mindful of our emotions and biases, let's talk about some approaches to debt management.

Autopilot: leave it alone - for now

"Autopilot" simply means "pay the normal/minimum payment". There are two scenarios where this is likely the best option.

One is that you haven't yet reached that rung on the financial ladder. If you don't have some form of cash flow management, at least a starter emergency savings fund, and basic insurance, attacking your debt first can leave you vulnerable. Even a minor emergency could send you two (or five, or ten!) steps back; I recommend addressing those rungs on the ladder first, so you have a solid foothold.

Now, to be clear, I don't recommend just taking your sweet time -- for most people, those rungs should be an urgent priority that they can knock out in 1-3 months. If your debt is really bothering you, then consider that rung a "reward" for taking care of the rungs before it. Again, this is about psychology!

The other autopilot scenario applies to relatively low-interest, fixed-term debts like student loans and mortgages. In this case, it may make sense simply to make the normal payments until the term is up. If the debt is low-interest, then it may improve your long-term projections to invest your money rather than pay off a debt early. (This is where Monte Carlo simulations can help.) Having said that, also take a look at your short-term flexibility and the "50" part of the 50/20/10 rule. If your non-discretionary expenses are high, it may make sense to pay off the debt early, even if Monte Carlo says otherwise!

Snowball: make psychology work for you

The "snowball method" of debt management turns the tables by making psychology work for you. It works like this:

  1. Set aside money each month to pay down your lowest-balance debt, above the minimum payment.

  2. Once that debt is paid off, take that total payment and add it to the payment you're making towards your next-lowest-balance debt.

  3. Keep going until all targeted debts are paid off.

You see how "snowball" is a fitting analogy here; by the time you get to the last debt: you have this massive snowball of all of your other debt payments.

The advantage of this method is that it uses psychology to keep you motivated -- because you started with your lowest balance debt, you got a "quick win" to help kickstart your motivation. And by the time you get to your largest debt, you've got a nice "snowball" of payments to knock it down that much faster!

Avalanche: make the numbers work for you

Avalanche works like the snowball, except instead of attacking your debts in order of balance, you attack them in order of interest rate. Running the numbers, you might wonder why anyone would choose snowball over avalanche; the math is pretty clear!

However, remember that debt management is as much about psychology as it is about the numbers. Sure, in an ideal world, avalanche is always better -- but if you run out of steam in the third month of debt management because that high-interest debt just doesn't seem to be moving, it's not terribly effective.

That said, I know some people who just naturally gravitate towards whatever makes numerical sense -- knowing that they've "run the numbers" gives them all the motivation they need. If that's you, then avalanche away, my friend!

Snowflake: little things add up

The idea of the "snowflake method" is to take little bits of "found money" and apply it to whatever debt you're currently targeting. "Found money" includes things like: birthday cash, money from selling personal items, tax refunds, and suchlike. And you can get creative!

For example: any time you use a coupon or otherwise get a discount, take that discount and apply it towards your targeted debt.

Another example: take any spare change and put it towards your debt. There are even apps like ChangEd that apply this concept to credit card purchases!

(Note: this applies just as well to any other financial goal, like building emergency savings or saving for retirement. For example, Acorns is like ChangEd, but for investments.)

"But this is small stuff," you say. "Why bother?" Because financial success is about many small steps, taken consistently, over time. Let me say that again: financial success is about many small steps, taken consistently, over time. (Funny thing: diet is like this too. And exercise. And lots of other aspects of life.) Particularly in the world of finance, small steps taken early compound over time!

Debt refinance: proceed with caution

Refinancing high-interest debts into a lower-interest one can be an easy win...but be careful here, especially if you're refinancing your credit cards. I've seen people with the best of intentions move their CC balance to another loan...and then promptly max out their CC, basking in the glow of their success and using "moral license" to dig themselves into even deeper holes. Make sure you have an ironclad cash flow management plan before going down this route -- cut up your cards or put them on ice, if you have to!

With that out of the way: how do you go about refinancing your debt? There are several options.

Home equity loan (HEL): the lowest interest rate loan you can generally find is one against your house. Nothing like collateral to make a bank lower its interest rate! Of course, this is your house; everything I said about proceeding with caution applies double here!

Unsecured personal loan: if a HEL is off the table, banks are still often willing to give you an "unsecured" (no-collateral) loan at a rate well below what credit cards charge. The best rates are generally to be found at credit unions.

Peer-to-peer lending: if for whatever reason the bank doesn't work out, you can look at peer-to-peer lending. Companies like Prosper and LendingClub enable people to lend directly to their peers, allowing you to take out a loan that's actually a combination of many smaller ones. While you'll still undergo an application process, there are many situations where you can take out a P2P loan that a bank would deny.

Student loan refinancing: this falls under its own category. First off, many of the methods above (barring perhaps a HEL) generally don't make sense with student loans, given the relatively low interest rates. More importantly, refinancing out of a federal student loan can cause you to lose the potential benefits associated with it. If you're looking at refinancing a student loan, do your homework! Consider checkng out financial planner Travis Hornsby's resources at Student Loan Planner.

Debt settlement: run away!

Just don't go there. "Debt settlement" involves letting your debt go into default, thereby giving the debt settlement company leverage to negotiate for a reduced payment. As you can imagine, this completely trashes your credit score. If you're at the point where you're seriously considering something like this, look at non-profit debt management companies instead.

Non-profit debt management: when you're in dire straits

If debt settlement companies are the dark side of the Force ("quicker, easier, more seductive"), non-profit debt management companies are the light side. On the surface, they look like debt settlement companies, working to negotiate lower debt payments, but they don't do this by letting your loan go into default. Rather, they're able to negotiate a lower rate by this simple fact: being part of a debt management program makes it more likely that you'll pay off your debts in a timely fashion, and thus makes you less of a risk. (And no, it doesn't generally hurt your credit score -- quite the opposite!) Check out the NFCC for more info on these.

Choose your own adventure(s)

Of course, none of these tools have to be used in isolation. You could use a combination of refinance + avalanch, or snowball + snowflake -- whatever makes sense for your particular situation! And if you've got a question on this front, don't hesitate to drop me a line or leave a comment.

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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