Episode 4:  Reducing Debt

In this show, Mike and Amy discuss the number 3 most popular New Years’ Resolution – paying down debt.  Mike and Amy cover: 

1. The US consumer debt problem (2:09)
2. Types of Debt (6:53)
3. “Good” vs “Bad” Debt (8:37)
4. Debt to income ratio and importance of having a debt management strategy (12:09)
5. Debt heading into retirement (14:31)
6. Approaches to paying down debt (16:40)
7. Balancing savings and debt pay off goals (21:24
8. Amy summarizes the key concepts (24:07)

 

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Disclaimer: This podcast represents the views of the hosts and any guests. It is for informational purposes only and should not be considered tax, financial, or legal advice. All information is regarded to be from reliable sources. The hosts are not responsible for any losses, damages, or liabilities that may arise from the use of this podcast. This podcast is not intended to replace professional, individualized advice.

Transcript:

00:00:34 Amy:

Hey, Mike, how’s it going?

00:00:36 Mike:

Good. How are you?

00:00:38 Amy:

Doing well, you know, we’re a little bit into the new year at this point and I think for most, if not everyone, the newness has worn off of everything. So we’re getting to the time of year where the choices you make today determine whether you’re still going to the gym or staying on track with your other goals. Even though we’re in the dark time of winter and it’s kind of sleepy, this is an important time of year in terms of continuing with goals or not.

00:01:17 Mike: Yeah, I completely agree. It’s kind of that make or break time. Whether you miss a day or two or depending on your goal, if you tumble, you have the choice of saying, “Okay, I’m done” or “Hey, do I get back on the horse and keep going?” So, yeah, it’s a critical time to ensure your resolutions are still in place at the end of the year.

00:01:47 Amy: Yeah, exactly. So, Mike, what are we going to talk about today?

00:01:54 Mike: Today, we’re talking about debt—how to manage it appropriately and how to get out of it if you have more than you think you should.

00:02:09 Amy: That is a great topic for discussion. You know, statistics can be boring, but I found some notable ones. The New York Federal Reserve recently published a report stating that US households are carrying $17.29 trillion in debt. Trillion is a really hard number to comprehend. So, if we think about what $1,000,000 means, even that is a huge number for many people. But if you imagine multiplying that by another million, that’s a trillion. That’s how big this number is. And a lot of that debt is mortgage debt—more than half of it, which is collateralized by your house, presumably increasing in value over time. It gives you a place to live, so it’s useful. But of that $17.29 trillion, a trillion dollars is just credit card debt—straight-up consumer debt. Another $1.6 trillion is auto loan debt. So these are just huge numbers for Americans. Even if you break it down per American, it’s a lot of money. Some American families are facing financial disaster as a result of their debt load. So I feel like this is a really important topic to dig into today.

00:04:05 Mike: Yeah, it definitely is. And the numbers are staggering when you just think of them in an abstract way. So it’s often useful to compare them to inflation or the size of the overall economy and how fast they’re changing. Student loan debt, for example, is just going up and up and up. When you talk about credit card debt, it just crossed a trillion dollars, I think for the first time. But when you look at it in the overall scope of the economy or how much it’s grown over the past few years, we’re trending higher, but it’s not out of control. Auto loans are interesting because autos are getting more expensive, and people are financing them for longer. But we’re also seeing payments center— the number of payments that are over $1000 a month for new cars is just going up. Again, it’s useful to think of it in terms of inflation and how that all works together, but you can get behind, and you can have issues if you’re not managing your debt correctly.

00:05:27 Amy: Yeah. And you made a really good point about what payments are and things like that. So it then ends up translating into cash flow that’s coming in that you don’t get to choose what happens with it. You’ve already spent that money. But before we go any further, I think it’s important for people to understand the kinds of debt that are out there. When I was running through those statistics, I talked about mortgages and car loans, which are loans backed by an asset—collateral loans. Then there’s other kinds of loans like revolving credit. Can you talk to us a little bit about categorizing debt and what each category’s characteristics are?

00:06:53 Mike: Yeah, there are two primary ways that debt gets broken down. One is secured, which is the collateral you were talking about, where there’s some asset that if you don’t pay, the lender could go and take. That could be a car or a house. All of those types of things fall into secured. The other is unsecured. That’s your credit card or a student loan where there’s no asset that they can come and take. You’ve already taken the trip, and they don’t really want your TV, for example. Then there’s whether it’s installment credit or revolving credit. Installment credit is where you borrow a big lump sum, say for a mortgage or a car, and then you have fixed payments over a set amount of time. Revolving credit, like credit cards, says you can borrow up to a certain limit. If you borrow $8000 out of $10,000, you still have $2000 available. But if you pay that off and get down to $2000, you can borrow more. It’s in and out, and your payments change every month based on how much you owe at that time.

00:08:37 Amy: Yeah, and I think, in addition to the factual ways to characterize debt, it might be useful to talk about the philosophical ways of classifying debt. For as many people as there are in our country, there are different perspectives on it. That is probably how many philosophies there are around debt, but one of the most common ways to categorize debt is this idea of useful debt or leverage that can help you enhance the use of your money. The things that might get categorized that way are things like a mortgage for your primary home. So like I said before, typically your home will increase in value over a period of time, so even if you buy at the top of a bubble, if you end up staying in the home, there’s a very good chance that you will walk away with more money. For example, if you bought it for $300,000, there’s a very good chance that if you’ve kept it for 30 years, it will be worth more than $300,000, maybe even in excess of inflation over that period of time. But if nothing else, you’ve gained a place to live, and your mortgage payments are locked in. It’s not like a rent payment that might go up every year, so that can be perceived as good debt or leverage that helps you make more use of your money. Student loans are sometimes categorized that way as well, so you spend money to go to college in order to be more educated and have a chance at having a higher income job. Again, there are different philosophies around each of those examples. But then there’s what people might call bad debt or debt that doesn’t give you leverage per se and that’s things like, you know, oftentimes credit cards are lumped in here because you can spend money that you don’t have to. But you’re basically signing yourself up for having to pay later, so there’s a ton of different kinds of and often revolving credit is categorized in this way. But it’s really important for you to identify what you feel are the philosophical differences between kinds of debt because sometimes you’re going to need to take on debt. Most people don’t have $300,000 to just go buy a house, and if you did, does it even make sense to do that? Sometimes it doesn’t. Sometimes it makes more sense to take the debt. But it’s just important for you to understand that there are philosophical differences and you need to be really clear about what your philosophy on debt is as you consider how you want to approach your debt. And what makes you feel worse than other parts of your debt, so if you just have a mortgage, maybe it makes you uncomfortable to just have a mortgage. But if you have several credit cards and an auto loan. What are the debts that have you most concerned? I just think that is a very long-winded way of saying that philosophy matters and how you feel about this matters.”

12:09 Mike: “Yeah. No, those are all great points and one of the other pieces is just looking at your overall debt to income ratio and understanding that and how credit scores myriad other things, but if your debts climb too high, even they’re useful. Typically you’re going to have a harder time borrowing or future loans at higher rates because you’re viewed as a more credit risk bank lending agency that doesn’t want to give even more money. So yeah. Understanding bad debt just managing it, having a plan is incredibly important for any kind of debt discussion.

00:13:09 Amy:

Yeah, I agree. Especially because, you know, it’s unlikely you’re going to be able to pay every single thing in cash. So at some point, you will need debt for some reason, one or another, and if you can come to the table with a great credit score and history. Then you can get much favorable terms, which can make a huge difference over the long term. And I think that’s like launching into you know, so far we’ve talked about things in very general nature, all our comments apply to anybody, but this show about retirement preparing for retirement. And I think what’s really important about debt management as you get ready to head into retirement is keep in mind that everything as you start to prepare for transition, whether it’s a military transition to the private sector or for retirement, everything feels a lot more urgent and emotions become very difficult to manage. So sooner you can get a handle on your debt and have a plan reducing manageable level head into retirement, more smooth transition you’ll have heading into retirement. What are your thoughts around that, Mike?

00:14:31 Mike:

Yeah, I totally agree. Especially when you’re talking about ultimate retirement. Having to handle it because again, if you’re going to actually stop working, you know what, what money do you have coming that’s going to be able to pay off those debts? And that all needs be factored in. So if you’re, you know, it’s best to handle it well before you retire now. You know if you have a mortgage because you need a place to live because you just relocated for retirement. But you have a pension or some other options. Social Security for getting money. But again, looking at that kind debt to income ratio of. Do you have enough money coming to service all debt as you get into retirement and for military retirement? It’s having have an optionality, mean if you are you know in have excess debt, it can limit your options for taking job you really want versus you know having take job because you’ve got make those payments for things you know you’ve already bought, so yeah, that’s it’s incredibly important as you as you look at retirement future.

00:15:59 Amy:

Yeah. Yeah. That’s again, back to options. You know, having money available to you. Whether it’s because you saved or it’s because you have full use of all your cash flow versus some or a lot it being earmarked for expenses already exists you is a huge deal. So as people start to get a handle on their debt they want to start getting a handle on their debt as they sort of enter the retirement red zone, that is 5-10 years prior to retirement. What are some ways that people can sort of approach debt reduction or debt management?

00:16:40 Mike:

Yeah, there’s definitely a bunch different thoughts on this that people do and have used successfully. What’s the highest rate I’m paying, you know, right now credit card is, you know, close to, if not over 20% annual interest rates compared to you may have mortgage locked for you know, 3 1/2 and even if you’re borrowing today, it’s seven or eight. But compared to 20% that’s a lot lower, so you’d want to, you know, order all your debts by how much they are paying in interest. Just attack those that have the highest rates then slowly work through that list. The one key piece is. Don’t go back and add more debt unless you’re talking about, OK, maybe I’m going to refinance. I’m going to take out a loan or a credit card at a teaser rate for a year. And I’m really sure I can pay off all this if I move it to the 0% card and you know, would be diligent to pay it off. But what you don’t want to do is build up more debt back on that old credit card after you paid it off. So that’s one highest lowest, by the way. The another one is called snowball method, where you pick smallest amount owe could be credit card or just one off, store credit card and maybe got couple $100 on there and just knock that one out and so then you’re done paying that off and then you can roll payments over next highest balance owe, so you keep doing that to just kind get some mental wins, guess where you’re clearing some debts that have and you know taking those down one at time it can go faster, you know and and in mind you like having win and you move on next. But in those cases, maybe you’re not worried about which is the highest rate, you’re just trying to clear a whole account. Now, as quickly as. So I personally favor the, you know, looking at rates, especially if you have high interest rate debts just knocking those out because when you when you look at how much money you’re sending bank credit card companies in interest getting that down and then being able apply all that to interest principle lower amounts, you’re going make faster progress in my mind now. So. So that’s what I favor. How about you?

00:19:32 Amy:

Yeah. So you know, I mentioned before just how emotional things can get. And in my experience, clients get very emotional around that and. And so I actually favor a blend of the first two that you mentioned. So you know there’s no doubt that the highest to lowest rate. You know, paying off the highest rate debt first makes the most sense from a number standpoint. I just, I can’t think of a time where that wouldn’t be true. There could be times, but for the most part that’s going to be the least amount of money that you’re going to pay, having said. That depends on where a client is when we start talking about debt, if they need a win, then we’re just going to pay off whatever is the smallest first because they get a win and that makes them. Feel a little? Bit better about themselves so that then we can. Get to work. On making sure that you know they’re not spending new money. Like, we’re not taking on new debt. And then we can start working on it. Highest or lowest? Rate and there might be times when you know they’re starting to get down, you know, just like we’ve been talking about with the New Year’s resolutions, we’re kind of at that time of the year where it’s hard to. It’s new. It’s not new anymore. The excitement is worn off. The grind of doing whatever it is that you said that you were going. To do. Is a grind and so sometimes you just need an extra sort of emotional boost, and so then I will go back and say, OK, well, let’s just get this one handled because now they get a new one. Emotional boost because, you know, we can’t ignore the emotions around money. There’s the number side of money and the emotion side of money. And I just think that particularly for debt management, the emotions are a big deal.

00:21:24 Mike: Yeah, they definitely are. And kind of one other question, how do you, how do you balance the saving versus paying down debt side of things?

00:21:37 Yeah, yeah. Last week we taught. Or the last podcast we talked about savings and pretty soon we’ll talk about budgeting and trying to get a balance between. All of it. But you know, this is another hard thing. I am an advocate of putting some minimal form of an emergency fund together, and that might be, you know, that might be your car insurance deductible. So whether it’s 500 bucks, 1000 bucks in the bank in case something. Happens or it might be as much as $5000 if you got a little bit more going on. So I am in favor of having some basic emergency fund not fully funded, but basic emergency fund to try and prevent the new debt and it sort of mentally helps people too. And it starts to train them that This is Money that you can never touch because at some point we do want a fully funded emergency fund and that and we do want. Clients to sort of be trained that that’s not money, that’s for use. That’s, you know, it might be thirty $40,000 just sitting there. That’s not for a new car that is your emergency fund and new cars are not emergencies so that’s sort of how I. Approach it, how about you?

22:56 Mike: Yeah, similar. You know, I try again I get back to the credit card, but looking at the percentage that they are charging and what you’re going to be making in even a high yield savings account right now or in the even if you know. Put it in the market. You’re probably not gonna, you know, return that even if you catch that hot lucky stock. So you know I’m. I’m in favor of, hey, let’s, let’s get after the debt. You know, maybe like you said, having that emergency fund. But let’s divert savings to where we know we’ve got a fixed rate of return and let’s knock out that debt even if it means. You know, slowing down savings or pausing savings before we start that up again.

23:53 Amy: Yeah, yeah, I agree with that.

23:54 Mike: Well, that’s great. Anything else or we’re kind of the key takeaways that we want to leave Folks with today, Amy.

24:07 Amy: Yeah, I think you know, I think one of the key points that you had is critical to the discussion. We focused very much on sort of the kinds and debt management and that kind of stuff. But first and foremost, the first key takeaway is you have to reduce spending. You can’t take on new Debt while you’re trying to pay down debt. So it doesn’t matter how great your debt management plan is, it doesn’t matter which version of you know highest to lowest rate or debt. Snowball you picked. Unless you reduce expenses to less than your income, you’re never going to make progress with your debt. Management plan. So that’s the first thing. The second thing is, you know the fact that debt can have a real impact on. Your ability to retire successfully. So getting a plan in place. Preferably before you. Hit that retirement red zone. The five to 10 years before retirement, but certainly as early in that ride zone as possible. Having a debt management plan. To get that down to a manageable level in retirement and then last, I think it’s really important to keep in mind that debt is emotional. So if you’re experiencing Sleeplessness  at night. That’s the emotions of, you know , that are linked to debt and controlling your emotions throughout the debt management process is at least as important as the, you know, logistical, financial process of getting out of debt. So if you need to hire somebody, whether it’s a financial coach or you need an accountability partner. On that, you’re comfortable talking to money, talking about money with or an actual financial planner. Even though you’re dealing with debt, it could still make a lot of sense for you to bring somebody on board to help you control your emotions and put together a good plan that you can stick to. Anything else, Mike, that you think has a key point here?

00:26:09 Mike:

No, I think I think you hit the main takeaways, I think next time we’re going to as, as you alluded to, probably talk about the budget again. Not a fan, but we can get into that next episode.

00:26:28 Amy:

That sounds good, Mike. I look forward to it, I do like budgets, but I know they’re not popular.