August 8, 2020
6 second take: It may sound strange, but putting money aside instead of paying off more debt could save you bing in the long run.
Pay off debt by building savings: Sometimes the most appropriate thing to do can seem counterintuitive. This is true when dealing with problem debt. People often put a lot of thought and analysis into their debt payment methodology. And they often move sideways, the debt bouncing around without coming down in any appreciable manner. The solution is to pay off the debt by building savings.
Debt and savings don’t coexist for problem debtors. If you’re having problems with debt, savings has probably long since left the premises. People with $5,000, $10,000, or $20,000 in accumulated revolving debt have no savings.
They may have some investments, perhaps a 401(k) balance or some other not-easy-to-tap account. But no savings account balance. Savings and debt just don’t go together. The cause of debt — spending in excess of spendable income — drove savings out of the picture long before the debt became clearly significant.
How and Why Large Debt Occurs
There’s a pearl of conventional wisdom that says where the debt comes from doesn’t matter; you simply need to focus on moving forward in a new debt-free lifestyle. Yes and no. It doesn’t matter — except that it does.
Debt can come from identifiable or nonidentifiable sources.
An identifiable source of debt is a specific cause. An identifiable cause of debt happens when a situation occurs where you had no appreciable debt; an event with significant unplanned expense occurs, and you have debt after.
This could be a significant uninsured medical expense, living expenses with a protracted period of unemployment, or some other major, specific financial cost. It’s something you can put your finger on, as in we had no debt, then we had $8,000 of uninsured medical bills as the result of an accident, and we’re now $10,000 in debt.
The two things to note are that nearly all of the debt is traceable to a single and specific event, but also that it isn’t necessarily 100 percent of the cause.
Debt from a nonidentifiable cause is missing the clear linkage. You may be able to trace a portion, but not the majority, to an event. It sounds more like: We have $20,000 in debt, $3,000 is from new appliances and $2,000 from the lawn tractor. Debt from an unidentifiable cause is from a spending problem, not from an event.
The difference is radically important. People with debt from an identifiable source beyond their control need to pay off debt by building savings. People with debt from a nonidentifiable source need to do the same thing plus reel in their spending habits or they’ll just end up back in the same place.
No one likes to think it’s their spending that’s the problem.
What I find interesting is that in most cases debt problems don’t come about as the result of a single bad decision. Generally, most of the decisions don’t qualify as so bad that they’re a problem on their own.
The problem is the compound effect of a series of decisions. Perhaps you could have afforded the appliances, or the lawn tractor, or the new furniture, or the vacation. But not all of them. None of them was a horrible decision; collectively they’re a big problem.
That’s one reason debt is so difficult. It doesn’t have to come from one bad decision. It comes from not having a handle on the big picture.
The Cyclical Problem of Debt
We all have unexpected expenses. They’re actually quite predictable. We know we’ll have car repairs or house repairs, or deductibles, or need to replace an appliance or a computer. Many of these things crop up unexpectedly. We know we’ll have them. What we don’t know is which ones or exactly how much.
The solution to these problem expenses is to have a buffer — an emergency fund. When we don’t have an emergency fund we’re forced to find some other way to pay for the unexpected expense — which really can be expected to occur, only the details can’t be preplanned.
When we don’t have an emergency fund, we use debt. That’s the next place to go. If you don’t have cash of your own, you’ll need to get some of someone else’s. The credit companies are more than happy to supply you with some of theirs. At a cost.
This is what causes the cyclical problem of debt. Debt burdens our cash flow.
Here’s a hint: If debt didn’t burden our cash flow, it wouldn’t have accumulated.
If you have $20,000 in credit card debt and the large monthly payment that comes with that financial anchor, it makes it tough to get ahead. If you apply everything you can to the debt and an unexpected expense occurs, you have no options. You don’t have cash of your own, you’ll have to use theirs. At a cost.
This is why so many people struggle with paying down debt. The debt moves sideways, you pay and you pay and you have unexpected expenses and the balance is the same as it was when you started.
An Alternative to Pay Off Debt That Works
There is an alternative that works. In order to be successful in paying down debt, you should save some money.
Instead of maximizing your debt payments allocate a few hundred a month toward building a cash reserve. Make this few hundred a non-negotiable part of your budget. This is part of paying yourself first, of building savings before other expenses.
Your modest savings quickly becomes your buffer against these unexpected expenses — those that you can expect, you just don’t know which ones.
Now you have cash to pay for these minor emergencies, making them often not an emergency at all — more of an inconvenience.
A second thing happens during this process, and this is the kicker. This, small, subtle, nearly invisible thing makes the difference. You stop putting other crap on the credit card.
You may hate to admit you were doing that. But 99 percent of you were. You were getting the car fixed and getting pizza. You were making a copayment at the doctor’s office and picking up Chinese food on the way home. Couple hundred in car repairs and 20 bucks for pizza, doesn’t matter, right? Fifty bucks for a copay and 30 bucks for fast food, doesn’t matter, right?
It matters. It always mattered.
How to Pay Off Debt: Squiggly and Straight Lines
There’s always going to be a squiggly line.
If you focus only on the debt without building any sort of a buffer, then the debt will be the squiggly line. It will come down, go up, come down, go up — it will be squiggly and move sideways.
If you save and don’t use the card(s), the debt will begin a shallow descent. It is free to descend unimpeded by additional charges; it descends in a straight line. Your emergency fund will get the squiggly. It will build a little, get hit with one of those unexpected/expected expenses and drop, build a little and drop — it will be squiggly.
There will always be those who argue your only business when in debt is to pay down debt. Let them argue with themselves; that’s fine. You just need to do what works.
Building an emergency fund and being prepared for unexpected expenses is part of being financially responsible and managing your money wisely. There’s no need to wait. Building an emergency fund while paying down debt has helped many people become debt-free. Pay off debt by building savings and you could find yourself among the debt-free sooner than you think. Let your emergency fund take on the squiggly line so your debt can take the straight line out of your life.