If you’re like many Americans, the pandemic probably did a number on your personal finances.
Maybe you took on debt to make ends meet or let your spending get out of hand to satisfy your Amazon addiction while bored at home. (I certainly got to be on a first-name basis with my Amazon drivers over the last year.) With tax refunds starting to hit bank accounts along with stimulus checks, things are beginning to look up, and maybe you are wondering what to do with this newfound wealth.
One option might be to give your monthly budget some breathing room and get out of debt for good. The question is: How? Which debt dragon should you slay first?
You may have heard about a method called the debt snowball, popularized by author and personal finance pundit Dave Ramsey. It focuses on paying the debts with the smallest balances off first. Because personal finance is a lot more personal than finance, this method is quite popular because you get quick mental wins that might encourage you to keep going.
The method that makes the most sense from a math standpoint might be the debt avalanche (snowball … avalanche … get it?). This is where you rank your debts by the highest interest rate first and start chipping away. This method will save you the most money overall, but you might get discouraged by the feeling that you’re not making headway fast enough.
A third option is not as well-known but is my personal favorite. It comes from a little-known book called Killing Sacred Cows by Garrett B. Gunderson. As a certified financial planner professional, I do not agree with most of the book — for example, he calls the 401(k) a hoax — but I do think that this method of debt elimination is solid.
With this method, you calculate something called a cash flow index for each of your consumer debts based on just two numbers, the total balance and the minimum monthly payment. To get each debt’s cash flow index, divide the total balance by the minimum monthly payment.
You then start paying off the debt with the smallest cash flow index first, while continuing to make minimum payments on your other debts. The advantage of this strategy is it attacks the debt that will have the largest positive effect on your monthly cash flow first, which means that your monthly cash flow improves in the shortest time possible.
Any one of these methods can work to tackle your debt, though they all have advantages and drawbacks. If you want to pay the least amount of interest, the debt avalanche will work for you. If you feel like you aren’t getting anywhere with your debt, the debt snowball might be your best bet. If your monthly budget is feeling a little tight, the cash flow index method might work for you.
If you are still having trouble deciding or have a specific situation that is more complex, do not be afraid to talk to a financial professional to get the help you need. Your monthly budget will thank you — though maybe not your Amazon driver.
A.J. Kratz, CFA, CFP, is a Financial Advisor at Telarray, a Memphis-based wealth management firm.