Ch. 23: Managing Debt

23.0 Introduction

            Hopefully you enter this chapter with no enthusiasm.  I mean it. If you’re excited to learn about debt, it probably means you have a lot of it.  I hope that’s not the case for you, but if it is, I’m here to help! 

23.1 Meet Don

  Donnie Dumbass is all grown-up.  He was a great college buddy of yours, always had your back.  And he was a surprisingly good student, earning a 3.1 GPA and graduating in four years.   Now, Don needs your help.  He’s heard you’re pretty good “at the finances” and asks you to look at his financial situation.  You agree.  Here’s what you find:

  First off, let’s not cast any dispersions on poor Don (who, among other problems, was prompted to have a bad haircut).  Don isn’t necessarily in a bad financial situation, nor can we be certain that he made poor financial decisions.  Perhaps Don just finished his final year of medical school and is now destined to earn $500,000/year.  Or maybe he wisely selected a credit card with a 0% introductory interest rate that just ended.  Debt is not necessarily a sign of financial illiteracy or poor choices.

  After some digging, you find that Don is indeed in a fine position (financially, the rest of his life is a disaster).  He earns $188,000/year and saves a significant sum of money buying his vertically striped collared shirts at K-Mart.  He saves $4,000/month in a savings account and makes only the minimum monthly payment on his debt.  As his friend, how would you recommend paying off his debts?

23.2 Snowball Method

            There are two schools of thought regarding debt.  We will first discuss the snowball method, which is espoused by Dave Ramsey and his army of followers (sycophants?).  The snowball method is a simple debt payoff strategy that recommends the indebted to ignore interest rates and target paying off the smallest debt balances first.  Here are steps:

  If we decide to recommend the snowball method to Don, it will make for a quick conversation.  Take a gander back at Don’s debt—the final column shows the only values we will need to consider. While ensuring he is making at least the minimum payment on all debts[1], he should contribute as much as he can to his lowest debt balances.  He will first payoff his automobile loan, then his student loan, followed by his credit card, and finally, his mortgage.  

  The debt snowball method is simple, and perhaps this simplicity explains its appeal.  In experimental settings, the indebted seem to naturally gravitate towards a snowball payoff.[2]  While this method ignores interest rates, which should be a key variable in optimal decision-making, some researchers have found that individuals with credit cards have the most success in paying off debts when this method is used.[3]  Why?  Many have hypothesized that the snowball method creates “small wins” for the indebted.  By targeting smallest debts first, folks can quickly and clearly see the fruits of their labor, which serves to motivate them to continue their aggressive repayment plans. 

  However, I doubt the snowball method appeals to you.  By seeking out this book and developing your financial skills, you’re keenly aware of the perils of high-interest loans and will look for a more efficient repayment method.  Indeed, a 2016 found that the snowball method ultimately costs Americans about $50 billion (or about $1,300 per family) in excess debt payments relative to the forthcoming avalanche method.[4] 

23.3 Avalanche Method

            Under the avalanche method, the indebted seeks to payoff the highest interest rate loans first.  For someone with even a baseline level of financial skill, the logic is clear—by paying off high interest loans first, an individual can eliminate the costliest debts first.  So, if we are counseling Don, we would, of course, recommend that he pays at least the minimum on all balances.  Then, with his remaining funds, he should pay as much as he can to the loan with the highest interest rate.  Specifically, he should contribute as much as he can first to his credit card debt (19.99%), then his student loan (6.25%), mortgage (5.75%), and auto loan (5.50%).[5]

            Most educational media would end there, but this is an advanced book.  To optimize debt payoff, one should consider not the stated interest rate, but the effective interest rate.  The effective interest rate is the interest rate that one pays after taxes are considered.  For example, imagine you have two forms of debt: a student loan debt and an auto loan.  Both charge a flat 7.0% interest rate.  While the stated interest rates (7.0%) are equal, the effective interest rates are not.  As we learned in Chapter 22, student loan debt is an above-the-line deduction.[6] This means that any interest paid towards a student loan will reduce one’s taxable income.  If you are in the 22% marginal tax bracket, then $1,000 in student loan payments will yield a $1,000 reduction in taxable income and a $220 reduction in taxes.  Thus, paying $1,000 in student loan debt only costs you $780 once taxes are considered.  Since the debt is effectively 22% cheaper than it first appears, the effective interest rate is also 22% lower than is stated.[7]  Effective Interest Rates can be solved using the formula:

Effective Interest Rate = (Stated Interest Rate)(1 – Marginal Tax Rate)

Using our examples from above, the effective interest rate for your student loans will be solved as follows.

Effective Interest Rate, Student Loan = (7.0%)(1 – 0.22) = 5.46%

How about the 7.0% interest rate auto loan?  Under normal circumstances, there is no tax break for an auto loan.[8]  When you pay $1,000 in auto loan interest, there is no tax savings.  So, we need to be smart and recognize that the effective interest rate is the same as the stated interest rate—7.0%.  For most debts, the effective interest rate is the stated interest rate and the above formula does not apply.

            Now, let’s return to Don’s situation.  To provide guidance, we now need to know a lot more information about Don and we will soon see why an understanding of the income tax system is of vital importance. The table below reveals the tax status for each loan.

To determine the effective interest rate on Don’s loans, we will need to determine (a) his marginal tax rate and (2) his deduction status—is he taking the standard deduction or itemizing.  Let’s first assume that Don is in the 24% marginal tax bracket and is itemizing.  If Don is itemizing, then both the student loan and mortgage interest will be fully deductible.  We can solve for the effective interests rates:

Effective Interest Rate, Student Loan = (6.25%)(1 – 0.24) = 4.75%

Effective Interest Rate, Mortgage = (5.75%)(1 – 0.24) = 4.37%

The conversion from stated to effective interest rates leads to a debt payoff strategy that is quite different from what we would generate using the stated interest rates.  Optimally, Don should pay off the credit card debt first, then the auto loan, followed by the student loan, and finally his mortgage.

            The impact of human nature in personal finance cannot be ignore, but I would argue that you should try to ignore your emotions as much as possible.  So, if you have debt, I recommend you employ the avalanche method, with effective interest rates applied.  But if you’re giving advice to someone who is not so financially savvy, I can understand why the snowball method might be appealing. 

24.4 When is it wise to aggressively payoff debts?

            Some low-level thinkers tend to throw all debts into the same box.  This is unwise.  A 3% interest rate mortgage is very different from credit card debt with a 25% rate.  Every debt should be treated separately, and your decision-making should be directly determined by the effective interest rate on each form of debt.  If you have a 25% rate credit car loan, you should do just about everything you can to repay that debt as fast as possible.  If you have a 3% rate mortgage, you should probably pay the minimum.  Rates between these extremes can be tricky.  Here is my somewhat arbitrary for prioritizing debt payoffs within the structure of investing.  This system works well for me.  If you are deciding how to payoff debts and invest, you’ll have to decide where you draw the lines.

Priority 0:  Make the minimum payment on all debts

• Before you can even consider other options, make sure you are at least paying the minimum on all debts.

Priority 1:  Contribute the necessary amount to realize company matches

• High-interest debt is a pain, but it can be reasonable to choose not to pay off a high interest rate loan.  If you work for a firm that offers a 100% match on 401(k) contributions, I recommend making the necessary contribution to receive this match before paying off debts.

Priority 2:  Pay off debts with 10%+ effective interest rates

• Now, let’s get rid of those “bad debts”.  Even though you are making investment contributions, you’re in dire straits.  You should be living a meager lifestyle while you pay off this costly debt. 

Priority 3:  Contribute to an HSA and Roth IRA

• These two tax shelters offer unique benefits to the investor. The HSA is the only triple-tax-advantaged account.  Since the HSA can be invested (hopefully earning about 10%/year) and is so tax-efficient, it deserves to be fed.  Likewise, Roth IRAs, which provide the tax savings of other Roth shelters, but allow for withdrawal of contributions, should be prioritized.  Personally, I would fully max-out these accounts before aggressively paying off sub-10% interest loans.

Priority 4:  Pay off debts with 6% to 10% effective interest rate

• I expect to earn an interest rate of about 10% annually by investing, but I will generally choose to pay off a known 6% to 10% interest rate before investing (in accounts other than an HSA or Roth IRA).  Six percent is my line in the sand.  If the loan charges an effective rate of 6% or more, I will choose to pay off the loan before additional investing.  If the rate is less than 6%, I will take my chances investing in stocks.  This 6% line in the sand also applies to my decisions on whether to take-on additional debts.  I have the cash to buy a $20,000 car, but if I’m buying a car and am offered a 5.5% interest rate auto loan, I’ll take the loan!  As I get older, my tolerance for risk will decline and so will my line in the sand.

Priority 5:  Invest

• If the interest rates on my loans are all less than 6%, I will merely pay the minimum on all debts.  If I have $100 in disposable income, I’d rather invest that money (expect to earn more than 6%) than payoff a low-interest loan.

To reiterate, the priorities above match my risk tolerance and preferences.  Your views may be a bit different.  Regardless, if you have various forms of debt, I think it’s wise to build a priority schedule like mine to help you make informed decisions.

24.5 Conclusions

            As you can see, the decision-making framework for debt can be quite complicated and contains many factors.  To make optimal decisions, one must understand the income tax system, the value of various tax shelters, the impacts of compounding interest, etc.  And while I’m hopeful that you attain a level of financial security where you will not need high interest loans, debt is a part of life, even for financial wizards.  Prepare to be “in debt” even if you have a high net worth.

End Notes

[1] If Don fails to make the minimum payment, bad things will happen… He will be charged late fees, destroy his credit score, and potentially be the target of collection agencies or attorneys.  He could lose his car or his house. 

[2] Amar, Moty, Dan Ariely, Shahar Ayal, Cynthia E. Cryder, and Scott I. Rick. "Winning the battle but losing the war: The psychology of debt management." Journal of Marketing Research 48, no. SPL (2011): S38-S50.

[3] Gal, D., & McShane, B. B. (2012). Can Small Victories Help Win the War? Evidence from Consumer Debt Management. Journal of Marketing Research, 49(4), 487-501. https://doi.org/10.1509/jmr.11.0272

[4] Hamilton, B. (2023). Two steps forward, one step back? Quantifying the pecuniary costs of debt account aversion and the debt snowball. Southern Economic Journal, 89(3), 830–859. https://doi.org/10.1002/soej.12612 

[5] Let’s assume that these rates compound annually.  If not, one would first need to convert each rate to an effective annual rate.  Here’s how:  Effective Annual Interest Rate: Definition, Formula, and Example (investopedia.com).

[6] If you don’t understand what I’m talking about, get your ass back to Chapter 22.

[7] State income taxes matter too.  If you work in a state with an income tax, that also applies.  I’m choosing not to discuss state income taxes in this book since my readers live in many states.

[8] The most obvious exception is an auto loan for a business vehicle.  If you borrow money to buy a car that is used primarily for business operations, the interest may be an above-the-line deduction.

[9] Student loan interest is always deductible, but only up to the annual limit of $2,500. 

Key Terms

Avalanche Method:  Debt payoff strategy, in which the borrower prioritizes paying off the highest effective interest rate loans first.  The avalanche is the optimal method, mathematically.

Effective Interest Rate:  While an interest rate may be stated as 5%, the interest rate after tax considerations may be less. The effective interest rate indicates that true cost of borrowing.  For interest that is deductible, the effective interest rate is lower than the stated rate.

Snowball Method:  Debt payoff strategy, in which the borrower prioritizes paying off the lowest debt balances first.  While sub-optimal from a math standpoint, some research shows that borrowers are more successful in attaining debt freedom if they use this method.

Practice Problems

1. A married couple earns $91,000 from their jobs.  They have mortgage interest ($180,000 balance, 7.25% rate), credit card debt ($9,000, 14.75%), a personal loan ($1,500, 6.85%), and a student loan ($24,000, 8,00%). 

a.       If they decide to use the snowball method, what order should they payoff their loans?

They should prioritize paying off the smallest debts first.  So, they should fully payoff the personal loan, then the credit card debt, then the student loan, and finally the mortgage.

b.      What additional information do you need to know to determine their order of payoff if they use the avalanche method?

You would need information regarding their tax situation.  Ultimately, you need to know their marginal tax rate and whether they took the standard deduction or itemized.  You’ll probably need to help them; most folks don’t know their marginal tax rate. 

c.       After discussions, you find that they are in the 12% marginal tax bracket and they are not itemizing.  Solve for the effective interest rate on each loan.

Only the student loan is deductible.  Here are the effective rates:

Mortgage: 7.25%

Credit Card:  14.75%

Personal Loan:  6.85%

Student Loan = 8.00%(1 – 0.12) = 7.04%

d.      Based on your answer to C, in what order should they payoff their loans if they use the avalanche method?   

They should payoff the highest interest rates first

Order:  Credit Card, Mortgage, Student Loan, Personal Loan

2. Explain why it is important to at least make the minimum payment on all loans, regardless of interest rate and debt balance.

The minimum payment is the minimum to avoid costly fees.  If you pay less than the minimum, there will be extra charges.  Furthermore, it will hurt your credit score.  Finally, for some loans, there may be additional consequences.  For example, if you pay less than the minimum on an auto loan, your automobile may be seized by the lender.

3. I currently have a high-balance student loan.  I owe $144,000 and am charged 12.5% interest.  I just started a new gig that will pay me $100,000 and offers a 100% match on the first 4% of my salary.  I am currently on my parents’ health insurance plan. During the year, I should amass about $30,000 in disposable income to invest and payoff debts.  What should I do with this money?

In my opinion, you should contribute exactly $3,000 to your 401(k) to earn the full match.  Then, the remaining $27,000 should all be contributed to the loan.  (Note that this person does not have access to an HSA… they don’t have a health insurance plan of their own)

4. Kyra is a friend of yours.  You two are enjoying a couple of beers at happy hour and she says, “Hey, I need to brag real quick”.  She reveals that she has a mortgage with a 2.25% interest rate.  Right now, she owes $150,000 on this mortgage.  After years of diligent saving, she has $150,000 in a savings account earning 3.00% interest.  She brags that she will payoff her loan tomorrow and wants to go out for drinks tomorrow to celebrate.  What should you tell her?

“First of all, Kyra, do we really need to go out drinking again?  Secondly, you should not payoff the mortgage. Currently, the interest rate in your savings account is higher than your mortgage loan, so you are effectively profiting from the loan.”

You might also explain why it’s probably not a good idea to hold $150,000 in a savings account.  She should (arguably) take-on more risk.

Use the following information to answer questions 5-8.

Hunter is single and earns $195,000 as a programmer.  He is a member of an employer-sponsored health insurance plan. He contributes $20,000 to a traditional 401(k), $3,000 to an HSA, and $6,000 to a Roth IRA.  He pays $3,500 for health insurance premiums.  He has $5,000 in above-the-line deductions and $18,000 in itemizations.  He has no available credits and the following debts:

5. If he paying-off his loans using the snowball method, what should be his order of payoff?

Student Loan #2, Auto Loan, Student Loan #1, Mortgage Loan

6. Solve for his current marginal tax rate.  Note that you must go through the income tax steps to solve this.

Total Income = $195,000

Gross Income = $195,000 - $20,000 - $3,000 - $3,500 = $168,500

AGI = $168,500 - $5,000 = $163,500

Taxable Income = $163,500 - $18,000 = $145,500

He is in the 24% bracket.

7. Solve for the effective interest rate for each debt balance.

Auto Loan = 6.25%

Mortgage Loan = 7.45%(1 – 0.24) = 5.662%

     *This is deductible since Hunter is itemizing.

Student Loan #1:  8.75%(1 – 0.24) = 6.65%

Student Loan #2:  5.25%(1 – 0.24) = 3.99%

8. If Hunter uses the avalanche method, what should be his order of payoff?

Student Loan #1, Auto Loan, Mortgage Loan, Student Loan #2

Use the following information to answer questions 9-14.

Andrew and Jaida are married and live in a state that does not have a state income tax. They earn $258,000 in total income.  Most of this income comes from their regular jobs, but they also own a cabin that they rent-out for a profit.  They pay $17,500 in insurance premiums that are connected to Jaida’s employer. They make $6,000 in HSA contributions, $500 in limited use FSA contributions, $12,000 in traditional 403(b) contributions, $6,000 in Roth 457(b) contributions, and $12,000 in Roth IRA contributions. They have $20,000 in above-the-line deductions and $15,000 in potential itemizable deductions. They have three kids aged 4, 6, and 9.

They have the following debts:

9.       Solve for their US income tax bill for 2025.

Total Income = $258,000

Gross Income = $258,000 - $17,500 - $6,000 - $500 - $12,000 = $222,000

AGI = $222,000 - $20,000 = $202,000

Taxable Income = $202,000 - $29,200 = $172,800

Taxes without Credits = $27,844

Income Taxes = $27,844 - $6,000 = $21,844

10.       What is their marginal tax bracket?

22%, based on their taxable income.

11.       Are they itemizing? 

No.  They are taking the standard deduction.

12.       From a tax perspective, explain the difference between their two mortgage loans.

Since their rental property is for-profit, the mortgage loan is an above-the-line deduction (it’s a business expense).  Thus, the rental mortgage loan is deductible.  Their primary residence mortgage is not deductible since they are taking the standard deduction.

13.       Solve for the effective interest rate on each loan.

Auto Loan #1 = 6.95%

Auto Loan #2 = 4.45%

Mortgage Loan (rental property) = 4.75%(1 – 0.22) = 3.705%

Mortgage Loan (primary residence) = 4.25%

14.       If they payoff these loans using the avalanche method, what should be the order of payoff?

Auto Loan #1, Auto Loan #2, Mortgage Loan (primary residence), Mortgage Loan (rental property)