July 23, 2024
Hello, everyone! Thanks for joining us. You're watching Money Fundies. My name is Matt Stearns, and you're here at Millennial Money Management. If you missed our last episode, we talked about bonds, how they differ from stocks, how they are reacting right now in the marketplace, and just the general fundamentals to make you more aware of how they fit into a portfolio.
Today, we're going to change gears a little bit away from the investing side of things and talk more about personal finance, especially about debt management and the different strategies that we have when it comes to paying off different types of debt.
Okay, so in my profession, we have a few different strategies. Obviously, a custom strategy is best for each individual person, but I'll be going over two main ones, okay? And then I'll also be going over considerations about when's a good time to be investing instead of paying off your debt, saving instead of paying off your debt, or vice versa, because it's a popular question as well.
Okay, so the first strategy, and the most popular, the most highly recommended, and also the mathematically best way to pay down debt, is what we call the avalanche strategy. Okay, so let's assume that we have three different types of debt: we have student loan payments, we have a car payment, and we have the credit card payment. Credit card loans, okay? What we'll do is we'll take the highest interest rate loan first, pay that off most aggressively, and just pay the minimums on the other two loans. So, in this case, it would most likely be the credit card loan. So, we'll pay more than the minimum on that, as much as we can afford to pay, while also paying the minimum on the other two.
So, once that highest interest loan is eliminated, then we move on to the second highest, and then finally the lowest loan. So, as I said, this is the most highly recommended option. It pays down the highest interest quicker, so it reduces the amount of interest that's paid as you're paying off your loans.
The second option is more of a psychological option or a psychological strategy for paying down your loans, and this strategy says that we take the smallest balance, we pay it off first to eliminate one loan completely, no matter what interest rate it has, to give us a psychological effect. Alright, look, I paid off one loan; that's great! Now I can tackle these next two, and you move on to the next smallest loan. You pay off that regardless of the interest rate. So, for people that struggle with bills and paying down these loans, it gives them, you know, a little bit of anxiety. It's a way to kind of knock some loans out on the smaller ones in the beginning, and it gives you some momentum to pay off your loans going forward.
So, as I said, another option can be a customized option, which is a little bit of both. Maybe if you have a really small balance on your lowest interest loan, you want to, you know, be aggressive with that, but you also want to be aggressive with your credit card, and you leave the one in the middle; you just pay the minimum. So, one strategy doesn't necessarily work best. As I said, mathematically, we want to pay off the highest interest loans first, and most people understand this.
Okay, finally, I'm going to talk about a question that I get often: "Well, you know, I have these student loans, man! I've got $70,000; I can't afford to invest right now." And this usually sparks a discussion about, well, perhaps maybe you should be investing and just paying off, you know, your student loans at a minimum rate. And here's the reason for that.
So, we have one interest rate on the student loans. Let's pretend it's 5%. So, we could either be, you know, being charged interest on 5%, or the alternative would be to invest it and earn a return. So, we have to decide: do we think we can earn a return on our money that would normally go to be paying off that loan on the investment greater than 5%? Because if we could make more than 5% of the money, it makes more sense to invest it and earn that rate of return as opposed to paying off the loan.
However, investing does come with risk, naturally. So, not only might you not earn more than 5%, you might actually lose money, and the money that you were intending to pay off your loan would be all gone. Obviously, that would be a double whammy in a bad situation. But if we're talking about something like a student loan that maybe we're going to be paying on for 20 years, we can get closer to the average return in the stock market, which is close to about 10%. So, if we have a student loan around 5% or 6%, and we have a 20-year investment timeframe where we can expect to earn 10%, it makes more sense to pay off the minimum on the student loan and invest, you know, the rest of the money that you can afford to invest.
Okay, it makes more sense to have a return of 10% than to be spending that money to pay down interest of 5%. Okay, but that's just my two cents. That's all for today. Thank you for joining me! Catch us in the next episode; we're going to be talking about more personal finance matters. But if you liked what you saw today, please like, comment, share, and subscribe to my channel. And thanks for watching; we'll see you next time!
