Ascending the Pyramid of Financial Shit-Togetherness: Step #3
Like so many important things in life, getting your financial shit together is a series of steps, each one building upon the skills and knowledge gained in the previous.
In Step #1, you committed to learning how you are spending your money and decided how to make that data as meaningful as possible. In Step #2, you suffered through a dissertation on taxes but made it out alive, armed with a foundational understanding of the topic and an ability to whine about paying them in a more nuanced, intelligent manner. By completing these two steps, you’ve officially graduated to level 2 on the Pyramid of Financial Shit Togetherness! You may now consider your pecuniary poop moderately in a group!
That feeling when your fiscal diarrhea has finally flamed out.
But we aren’t stopping there, friend. The momentum you’re building is going to continue to catapult your ass toward the summit.
Alright, enough congratulatory backslaps and high-fives. Who is ready for some tough love on a Saturday morning? Grab your comfort blanket and a cup of coffee because this may sting a little but I promise it’s for the best: Until you have the courage to see things the way they truly are, you will never be nearly as successful as you can be. At anything.
This applies to literally every important area of your life. Your relationships, your finances, your job, your fitness, everything.
A common refrain in the personal development literature is that the hardest step to take when solving a problem in one of these areas is admitting that you have one. But here is the thing about this piece of advice: It’s one of the stupidest things I’ve heard in a long time.
If you have $40,000 in credit card debt, it’s going to be a hell of a lot harder to get rid of the debt than it is to acknowledge that it’s there.
If you have 100 or more pounds to lose, it’s going to take a lot more work to shed the weight than admitting in your heart of hearts that you need to slim down.
The truth is that although admitting you have a problem isn’t nearly as hard as solving it, facing reality is the essential first step on the journey. And rather than being vague about your current state, you need to be as specific as possible.
“I have a lot of student loan debt” is useless. “I have $55,450 in student loan debt and $12,000 of it has an 8% interest rate” is clear and concrete.
“My wife and I are struggling” isn’t really saying anything. “My wife and I haven’t had a meaningful conversation in months, there is palpable tension in the air whenever we are in the same room, and our sex life is purely theoretical” is more painful but much more useful.
Doing this type of critical examination of your life is difficult. There is never a great time to take it on – who wants to torpedo a good mood or make a bad mood worse by taking a clear-eyed look at the most dissatisfying area of their life? But lurking behind the superficial reasons to avoid this work is the real root cause of why it’s so hard: Fear.
Fear that you’ll discover things are worse than you thought.
Fear that it will trigger a deep sense of shame about neglecting something you shouldn’t have.
Fear that you will be too overwhelmed to do anything about it.
Fear that if you finally cut through the shit and actually confront reality, it will force you to make a change.
Here is one of the most powerful things I’ve learned in the last five years: Fear thrives on the unknown. Get it out of your head and put it down on paper.
The most powerful tool for combating fear.
An amorphous, vague fear is ten times worse (at least) than one that is categorized and captured on the page. As counter-intuitive as it may sound, digging into the details of your issues and documenting them will bring you peace of mind. Ultimate peace of mind only comes from actually solving the problems but confronting them in the cold light of day is a significant, meaningful step forward.
Knowing that your job is shit is a bottomless pit of anxiety. Knowing that you’re miserable at work because your boss gives you zero autonomy and you are surrounded by negative, pessimistic people five days/week gives the problem a name and a face (quick tangent: if the last sentence describes your job, put in your two weeks’ notice, it isn’t worth whatever they are paying you).
Nowhere is this truer than in your personal finances. If you aren’t willing to face the reality of your financial situation, warts and all, your quest to scale Mount Financial Shit-Togetherness ends before it truly began.
For many of us, the gnarliest wart we will find when we take an honest, detailed look at our finances is debt. More debt than we remembered taking on. Higher interest rates than we swear we signed up for. Longer timelines to pay off our accounts than even seems possible.
Fear not, young squire. The first concrete step you can and must take toward eliminating your debt is to get the lay of the land and then strategize your plan of attack.
Step #3. Understand Your Debts and Plan How You Are Going to Obliterate Them
Before we gather the gory details, let’s spend a minute on how to evaluate the importance of debt pay-off compared to the other potential uses of excess cash. The following concept is critical to understand when determining where paying off debt should fall on your hierarchy of financial priorities:
Paying off debt gives you a guaranteed rate of return = the interest rate on the debt.
There are no sure things in investing – for a decade pretty much everyone believed that the housing market would only go up and then 2008 happened. But there is a sure thing when it comes to paying off debt – every dollar you put toward decreasing the principal on your debt is one fewer dollar that would have been growing at the rate of interest every second of every day. This certainty is tremendously valuable.
For example, you can use this to your advantage if you happen to have credit card debt. Everyone knows that credit card debt is bad news. Just because you have some doesn’t mean you are a financial disaster or heinously irresponsible, but life is always better without it than with it.
A credit card executive enjoying his standard breakfast.
However, there is an often-overlooked silver lining to credit card debt: You have zero ambiguity about your top financial priority. Paying off your credit card debt is without a doubt the best thing you can do to improve your financial health. The ability to guarantee a return on your investment equal to the (almost certainly) sky-high interest rate on your credit card debt is something every foul-mouthed, testosterone-addled Wall Street trader would trade his bespoke alligator loafers for!
There is a beautiful simplicity to your financial plan that not everyone is lucky enough to have: Step #1. Pay off your credit card debt. Step #2. Ignore everything else until Step #1 is finished.
Now that you understand this important principle, it’s time to get down to work. Here is what you need to gather for every single outstanding debt you have:
The current balance: How much you owe in total. What would it take to pay it off with one check?
The interest rate: What it is costing you to owe this money. Lower is better.
The most recently monthly payment, broken down into principal and interest. Anytime you make a payment on any sort of debt (credit card, student loan, mortgage, whatever) your money goes into two separate buckets:
Principal: This is the meaningful part of your payment and the only part that actually reduces how much you owe.
Interest: This is the money you are lighting on fire for the right to spend money that you don’t have. Paying interest isn’t always a complete waste – taking on low interest rate debt so you can buy a house now rather than wait 15 years until you can buy it with cash generally makes a lot of sense. But make no mistake – this is a hefty fee that you pay each and every month for the privilege of spending money that you don’t yet have.
The sum of Principal and Interest will remain the same each month for some types of debt (typically mortgages, student loans, and car loans) and will vary for other types of debt (mainly credit cards).
For debts where the principal + interest remains fixed, a little more of each successive payment goes toward principal and a little less goes toward interest. Your first few payments are likely nearly all interest and hardly enough principal to make a dent. The longer the repayment period, the more this is true. If you’re ever really hankering for a swift kick in the gut, take a look at how much of your first mortgage payment actually went toward paying down the principal versus how much went towards interest. Now you understand why Dan Gilbert can buy skyscrapers like the rest of us buy paper towels.
Use this grid to make a list of all your debts, with a separate line for each account. For the principal/interest breakdown, just list how the most recent payment was split.
Now it’s time to strategize your approach for ridding yourself of the psychic weight that comes with owing money. There are two ways to consider paying off your debt and they both have awesome winter-themed names:
Debt Snowball
Full credit here goes to Dave Ramsey. He’s kind of a kooky guy but his insight here was brilliant.
Step #1. Sort your list of debts from smallest balance to largest balance.
Step #2. Take aim at the debt on the top of your list – the one with the smallest balance. Make the minimum payments on all of your debts and fling 100% of your extra cheese toward the smallest balance until it is dead and gone.
Step #3. Take the money you’ve been using to annihilate the smallest debt and attack the next smallest balance on the list.
Step #4. Continue in this fashion, working from smallest balance to largest balance until you are debt free.
The brilliance of this approach is that it takes advantage of human psychology to build a shit-ton of debt-destroying momentum. By paying off the small accounts first, you will feel a genuine sense of accomplishment and gain confidence in your ability to make meaningful improvements to your financial situation.
Debt Avalanche
Step #1. Sort your list of debts from highest interest rate to lowest interest rate.
Step #2. Make minimum payments on all accounts and point all your excess cash toward the debt with the highest interest rate.
Step #3. Bask in the warming glow of mathematical certainty that you are paying off your debt in the shortest possible period of time.
So, how do you choose which method to pursue? You know yourself better than most people (probably not better than anyone but that’s an entirely different post) so think about which has more natural appeal – the prospect of scoring a few tangible wins in a short period of time or the knowledge that you are solving a problem in the most efficient way possible?
If you are still split, go with the Debt Snowball unless you have a large spread between the highest and lowest interest rates or have any debts above 10% interest, in which case, go with the Avalanche.
It’s important to notice that this level of our pyramid omits a third step that naturally follows after the first two we’ve taken. We gathered information on all of our debt and then decided how we are going to attack it (Snowball vs. Avalanche) but we are not yet putting our plan into action. That comes soon but we still have a bit more foundational work to do first in Step #4. See you next week.