April is National Financial Literacy month so we are going back to financial planning basics. Last week we discussed the first two steps in the process toward financial independence used by many financial advisers, and promoted by financial media personalities such as Dave Ramsey.
The first two steps involve assembling an emergency fund and then a larger financial cushion account of six months of expenses to help address the potential curveballs thrown at us by life. After these steps the process then suggests moving onto reducing debt and saving for long-term goals.
One of the most common areas of resistance to these planning steps is questioning why paying off debt is step number three, instead of step number one. I completely understand the logic behind this resistance.
Paying off debt would seem like the highest financial priority to many people. After all, credit card companies and other lenders are typically charging interest far higher than banks are paying on savings. But finance is not just about math, and it certainly isn’t just about doing what feels good. Personal finance is also largely about human behavior, and the logic behind the sequential-step process endeavors to change behavior while it solves pre-existing challenges at the same time.
The rub is, it's very difficult to save money until you’ve actually saved some money. This means the first step in saving money is to change behavior to actually put aside money, essentially parting with something that could bring benefits or gratification today, to prepare for tomorrow. The good news is, in my experience, once the action of putting money aside is consistently completed just a handful of times, the behavior trait gains momentum, becoming almost self-sustaining. Effectively, often once some money is saved, saving itself becomes the motivator.
When the act of saving becomes the motivator, then consumption behavior is naturally impacted as well. Debt accumulation may stabilize, and the household is now ready to address pre-existing debts. In addition, if the emergency fund and six months of expenses accounts discussed last week are funded, then more money on a paycheck to paycheck basis should be functionally available to pay off debt.
Or in other words, the act of saving should have changed consumption habits and the accumulated savings provide more security to the household, so less balance has to be maintained in the operational accounts (checking account). The reduced consumption, combined with the funds having been directed to savings and the need to “hoard” less in checking, create the cash flow that can be directed aggressively toward paying off debt. So, in focusing on saving first (steps one and two), we’ve effectively created the behavioral tools needed to attack the household’s debt, hopefully without accumulating more debt as unexpected needs can now be dealt with by using money from savings.
When the household is ready to begin aggressively retiring debt, the first inclination is often to want to target the highest interest debts first. This is good logic, but I prefer to use what we refer to as the payment cascade approach instead.
The payment cascade approach targets debts that have the highest payment commitments, typically installment loans, and focuses on paying these debts off first. As the debts with the highest payments are paid off, the cash flow from the payments is then “cascaded” toward other debts in an order that continues rolling the freed-up cash flow forward to pay other debts faster.
As planners, we have software that helps plan with this process, but there are a number of online tools available as well. A search for “debt reduction calculator” should yield results.
With the topic of debt behind us, next week we will move on to saving for longer term goals, when we finally start getting into the subject of investing.