• Chapter 3: Navigating Debt

    • Chapter 3: Navigating Debt

    Key Terms

    Emergency Fund - Reserved funds for unforeseen expenses or financial emergencies. 

    Fixed Interest Rate - A set interest rate that remains constant over the life of a loan or investment. 

    Variable Interest Rate - An interest rate that fluctuates based on changes in the market or other factors. 

    Opportunity Cost - The potential benefits sacrificed when choosing one alternative over another. 

    Avalanche Method - Debt repayment strategy prioritizing high-interest debts to minimize overall interest paid. 

    Snowball Method - Debt repayment strategy focusing on paying off smaller debts first to build momentum.

    Deeper Dive into Debt

    As discussed in the last chapter, debt is borrowing money from someone or an organization to pay it back according to certain terms. In this chapter, we will focus on more aspects of debt and how it can be helpful but if not treated with proper care, it can be very harmful.

    Purpose of an Emergency Fund 

    (The Church of Jesus Christ of Latter-day Saints, 2017)

    Before learning more about debt, it is important to understand the purpose of an emergency fund. Like an emergency or fire escape plan, in the event of a financial crisis, you should have a course of action that is simple to follow. About managing trials, Elder Marvin J. Ashton asked, “Can you quietly sit down, review the facts, and list all the possible courses of action? Can you identify causes and determine remedies? Quiet contemplation can solve problems more quickly than frantic force” (Ashton, 1981). Determining how to handle financial crises beforehand will allow you to be emotionally and financially prepared when hardship strikes and can help you prevent some crises in the future.

    Emergency Fund 

    Content in this section comes from the Consumer Financial Protection Bureau 

    (Consumer Financial Protection Bureau, 2024).

    An emergency fund is a cash reserve that’s specifically set aside for unplanned expenses or financial emergencies. Some common examples include car repairs, home repairs, medical bills, or a loss of income. Emergency savings can be used for large or small unplanned bills or payments that are not part of your routine monthly expenses and spending. 

    Why do I need it?

    Without savings, a financial shock—even minor—could set you back, and if it turns into debt, it can potentially have a lasting impact. An emergency fund’s primary function is to keep you away from unnecessary debt if you experience a financial crisis. 

    Research suggests that individuals who struggle to recover from a financial shock have less savings to help protect against a future emergency. They may rely on credit cards or loans, which can lead to debt that’s generally harder to pay off. They may also pull from other savings, like retirement funds, to cover these costs.

    How much do I need in it?

    The amount you need to have in an emergency savings fund depends on your situation. The typical recommendation is to have three to six months’ worth of expenses saved up. However, it is important to think about your situation and how long you could survive without income. If you have transferable skills and experience, you may be able to find a new source of income faster than others who would need to do additional training or education. You can also think about the most common kind of unexpected expenses you’ve had in the past and how much they cost. This may help you set a goal for how much you want to have set aside. It is okay to start small and work up from there. 

    If you’re living paycheck to paycheck or don’t get paid the same amount each week or month, putting any money aside can feel difficult. But, even a small amount can provide some financial security.

    How do I build it?

    There are different strategies to get your savings started. These strategies cover a range of situations, including if you have a limited ability to save or if your pay tends to fluctuate. It may be that you could use all of these strategies, but if you have a limited ability to save, managing your cash flow or putting away a lump sum are the easiest ways to get started.

    Strategy: Create a savings habit

    Building savings of any size is easier when you can consistently put money away. It’s one of the fastest ways to see it grow. If you’re not in a regular practice of saving, there are a few key principles to creating and sticking to a savings habit:

    Who is this strategy helpful for: Anyone, but particularly those with consistent income. If you know you have a regular paycheck or money consistently coming in, you can create a habit to put some of that money towards an emergency savings fund.


    Strategy: Manage your cash flow

    Your cash flow is essentially the timing of when your money is coming in (your income) and going out (your expenses and spending). If the timing is off, you can find yourself running short at the end of the week or month, but if you’re actively tracking it, you’ll start to see opportunities to adjust your spending and savings.

    For example, you may be able to work with your creditors (like your landlord, utility companies, or credit card companies) to adjust the due dates for your bills, or you can use the weeks when you have more money available to move a little extra into savings.

    Who is this strategy helpful for: Anyone. This is one important first step in managing your money, regardless of whether you’re living paycheck to paycheck or have a tendency to spend more than your budget allows.


    Strategy: Take advantage of one-time opportunities to save

    There may also be certain times during the year when you get an influx of money. For many Americans, a tax refund can be one of the largest checks they receive all year. For others, there may be other times of the year, like a holiday or birthday, when you receive a cash gift. While it’s tempting to spend it, saving all or a portion of that money could help you quickly set up your emergency fund.

    Who is this strategy helpful for: Anyone but particularly those with irregular income. If you receive a large check from a tax refund or for some other reason, it’s always good to consider putting all or a portion of it away into savings.

    Strategy: Make your savings automatic

    Saving automatically is one of the easiest ways to make your savings consistent so you start to see it build over time. One common way to do this is to set up recurring transfers through your bank or credit union so money is moved automatically from your checking account to your savings account. Many countries use cash for their everyday transactions. If this applies to you, consider using a change jar where instead of losing or forgetting about your money, put that change in a jar. Once a month take that to the bank. You may be surprised to see how much you can save! Use your current practices and circumstances to your own benefit. You get to decide how much and how often, but once you have it set up, you’ll be making consistent contributions to your savings.

    It’s a good idea to be mindful of your balances, however, so you don’t incur overdraft fees if there’s not enough money in your checking account at the time of the automatic transaction. To help you stay mindful, consider setting up automatic notifications or calendar reminders to check your balance.

    Who is this strategy helpful for: Anyone, but particularly those with consistent income. Again, you can determine how much and how often to have money transferred between accounts, but you want to make sure you have money coming in. If your situation changes or your income changes, you can always adjust it.

    Strategy: Save through work

    Another way to save automatically is through your employer. In addition to employer-based contributions for retirement, you may have an option to split your paycheck between your checking and savings accounts. If you receive your paycheck through direct deposit, check with your employer to see if it’s possible to divide it between two accounts. If you’re tempted to spend your paycheck when you get it, this is an easy way to put money aside without having to think twice.

    Who is this strategy helpful for: Those with consistent income. Again, if you’re getting a check from your employer on a regular basis, pay yourself first by putting a portion of it automatically into savings.

    Where should I keep my emergency fund?

    Where you put your emergency fund depends on your situation. You want to make sure this fund is safe, accessible, and in a place where you’re not tempted to spend it on non-emergencies.

    Here are a few options for where to put your emergency savings, and you can choose the one that makes the most sense for you:

    When should I use it?

    Set some guidelines for yourself on what constitutes an emergency or unplanned expense. Not every unexpected expense is a dire emergency but try to stay consistent. Even if it’s not a trip to the emergency room, you may need it to pay for a medical bill that wasn’t covered by insurance.

    Having a reserve fund for financial shocks can help you avoid relying on other forms of credit or loans that can turn into debt. If you use a credit card or take out a loan to pay for these expenses, your one-time emergency expense may grow significantly larger than your original bill because of interest and fees.

    However, don’t be afraid to use it if you need it. If you spend down what’s in your emergency savings, just work to build it up again. Practicing your savings skills over time will make this easier.

    Prayerful Consideration

    There is no perfect answer as to how much you keep in your emergency fund. The same is true for where you choose to keep your funds. However, it is important to have an emergency fund of some sort. Prayerfully consider how these principles can best be applied to your unique situation. 

    Components of Debt

    (Stephens & ChatGPT, 2024)

    There are many different types of debt but they follow some key components for the most part.

    Key components of debt include:

    Good vs. Bad Debt

     (The Church of Jesus Christ of Latter-day Saints, 2017)

    Prophets have counseled that there are very few justifiable reasons to go into debt and that when you do incur debt you should pay it off as quickly as possible. President Gordon B. Hinckley taught that “reasonable debt for the purchase of an affordable home and perhaps for a few other necessary things is acceptable. But from where I sit, I see in a very vivid way the terrible tragedies of many who have unwisely borrowed for things they really do not need” (Hinckley, 1992).

    (ChatGPT, 2024)

    It is important to know that not all debt is treated equally. There are “good’ debts that are more acceptable if you need them and “bad” debts that you should try to avoid wherever possible.

    Good debt is generally considered to be an investment that has the potential to provide long-term financial benefits. This includes borrowing for education, as it can lead to increased earning potential, and taking out a mortgage to buy a home, which allows for building equity and potential property appreciation. Business loans for entrepreneurial endeavors are also often categorized as good debt, as they can contribute to future financial success.

    On the other hand, bad debt is typically associated with borrowing for non-essential and depreciating items. Credit card debt is a common example, especially when used to finance a lifestyle beyond one's means, as high-interest rates can lead to significant long-term costs. Loans for rapidly depreciating assets like cars or consumer goods are also considered bad debt, as the interest paid may outweigh the value of the purchased items. Personal loans with high-interest rates for non-essential expenditures, such as vacations or luxury items, fall into the category of bad debt as well.

    Ultimately, the key is to evaluate the purpose of the debt, its potential return on investment, and whether it aligns with your overall financial goals. Responsible debt management, understanding the terms and interest rates, and making timely payments are crucial practices regardless of the type of debt incurred.

    Fixed vs. Variable Interest Rates

     (Consumer Financial Protection Bureau, 2016)

    Fixed-rate financing means the interest rate on your loan does not change over the life of your loan. Variable-rate financing is where the interest rate on your loan can change, based on various factors. Usually, variable rates are tied to the prime rate or another rate called an “index.” 

    With a fixed rate, you can see your payment for each month and the total you will pay over the life of a loan. You might prefer fixed rates if you are looking for a loan payment that won’t change.

    With a variable-rate loan, the interest rate on the loan changes as the index rate changes, meaning that it could go up or down. Because your interest rate can go up, your monthly payment can also go up. The longer the term of the loan, the more risky a variable rate loan can be for a borrower because there is more time for rates to increase.

    The Decision on Debt

    There is no right or wrong answer when it comes to debt. Much of it comes down to affordability and personal preference. Some people are comfortable with having debt while others avoid it like a plague. Neither one is right or wrong, just a balance between what your heart wants and what your wallet can afford. Like many topics in personal finance, there is a personal and emotional side just as there is a financial and mathematical side. Both of these are important in the decision-making process of whether to take on debt or not.

    Emotional Impact of Debt

    (The Church of Jesus Christ of Latter-day Saints, 2017)

    We have all likely made an impulsive or emotional purchase. Sometimes we spend money when we feel discouraged or angry. Sometimes we spend money because we feel that we are entitled to reward ourselves. Sometimes a sale or promotion tempts us into believing we need something when we really don’t. There are many reasons why we spend money on things we don’t really need at the expense of paying for the things that matter most.

    It is natural for people to compare themselves with others, and we are bombarded with messages and advertisements encouraging us to purchase things we do not need. Sometimes we feel entitled to have things that we can’t afford or don’t really need. Giving in to coveting can quickly lead us to make unwise purchases.

    (ChatGPT, 2024)

    Having debt can evoke a range of emotional responses, with both positive and negative aspects. On the positive side, incurring debt for significant life investments like education or homeownership can bring a sense of accomplishment and satisfaction, as these endeavors often align with long-term goals and personal aspirations. Additionally, using debt strategically for business ventures or investments may generate feelings of empowerment and financial growth. 

    However, the emotional impact of debt is not solely positive. The burden of owing money, particularly when faced with high-interest rates or challenging financial circumstances, can lead to stress, anxiety, and a sense of financial insecurity. The pressure to meet monthly payments and the realization of long-term financial commitments may contribute to feelings of constraint and the postponement of other personal or lifestyle goals. Striking a balance between the positive and negative emotional aspects of debt involves thoughtful financial planning, responsible management, and a clear understanding of one's financial priorities and capabilities.

    Mathematical Impact of Debt

    (Stephens & ChatGPT, 2024)

    From a mathematical perspective, the use of debt presents both advantages and disadvantages. On the positive side, debt can provide access to resources that might not be immediately available, enabling you to make significant investments such as buying a home, starting a business, or pursuing education. In such cases, the mathematical advantage lies in leveraging borrowed funds to potentially generate returns that exceed the cost of the debt. 

    However, the cons are evident in the form of interest payments. Debt comes with associated interest costs, and the longer the debt persists, the more one may pay in interest over time, potentially outweighing the initial benefits. The compounding effect of high interest rates, especially with credit cards, can lead to a substantial increase in the total repayment amount. Mathematically evaluating the trade-off between the benefits and costs of debt is crucial to making informed financial decisions and managing one's overall financial health effectively.

    Opportunity Cost

    (Stephens & ChatGPT, 2024)

    Opportunity cost is a fundamental concept that underscores the notion that every financial decision involves trade-offs. It refers to the potential benefits or opportunities foregone when a particular choice is made. 

    For instance, when allocating funds to pay off debt rather than investing in the stock market, the opportunity cost is the potential investment gains that could have been earned. Similarly, choosing to spend money on non-essential items instead of saving for future goals represents an opportunity cost in terms of future financial security. Understanding opportunity cost is crucial in making informed financial decisions, as it prompts you to weigh the benefits of one choice against the forgone benefits of alternative options. By considering opportunity cost, you can strive to allocate resources in a way that aligns with their priorities and long-term financial objectives, ultimately optimizing their financial well-being.

    Debt Payoff  

    (FINRA, 2014)

    Debt doesn’t have to be forever. Eliminating it will make a big difference in your quest for wealth. Use your budget to eliminate one debt at a time. When a single debt is eliminated, take the income you were using to service that debt and apply it to the next. Applying the funds you have budgeted for debt reduction in a focused, deliberate way will help you pay off debts more quickly. As your budgeting skills improve, you’ll have more success paying off debts. There are two different strategies that can be used to reduce and eliminate debt: the avalanche or mathematical strategy and the snowball or psychological strategy. 

    Both advocate paying off debts completely; however, each strategy suggests paying them in a different order. Both strategies are effective; you’ll need to find the one that works best for you. Also, both strategies rely on a calculation that determines a minimum monthly payment required to pay off a balance in a certain amount of time. 

    Avalanche or Mathematical Strategy

    Almost any financial advisor will suggest the avalanche approach to debt elimination. This strategy advises paying off debts by focusing on eliminating the debt with the highest interest rate first, then the next highest. This method makes mathematical sense because it focuses effort on paying off the debts that cost the most money in interest. Here’s an example: 

    Taylor awakes one morning to realize that she’s out of college, but she’s in debt and needs to do something about it. She commits $700/month of her budget to eliminate her debt. Let’s say she’s facing the following debts: 

    Using the mathematical approach, Taylor would pay her debts in this order:

    If she pays her debts in this order, Taylor minimizes the total she will eventually pay in interest. The end result is her paying off the debts for the least amount of money. Following the mathematical approach, paying off her debts from highest to lowest interest rate took Taylor 55 months (about 4.6 years) and cost her $4,575.85 in interest. 

    Snowball or Psychological Strategy

     (FINRA, 2014)

    The snowball strategy to debt elimination is similar to the avalanche strategy in that it advocates focusing on one debt at a time, throwing everything you have toward that debt until it is gone and then moving to the next until all debt is eliminated. 

    However, for some, achieving success sooner rather than later gives them the psychological reinforcement they may need to stay on track. For some, behavior modification is more important than saving extra interest. With this approach, you ignore interest rates when determining the order in which you’ll pay off your debt and order the debts from lowest to highest balance. This should get those small debts paid off quickly, so you’ll start to see your plan is working soon after you begin. Using Taylor’s example from the avalanche approach, she would pay off her debts in this order:

    By paying off debts in this order, Taylor eliminates the smallest balance in the shortest time, giving her a sense of accomplishment. This approach will eventually cost Taylor more in total interest paid, but it will yield results quickly, which may be the difference between success and failure. Using the snowball strategy, paying off her debts in order from lowest to highest balance took Taylor 56 months (about 4.7 years) and cost her $5,200.71 in total interest.

    Avalanche & Snowball Comparison

     (FINRA, 2014)

    When the two strategies are compared, we can see that there is only a one-month difference in how long it took Taylor to pay off all of her debts, but there is a monetary difference of $624.86. Even though the snowball strategy costs more over time, Taylor started seeing her debts eliminated at a much faster pace. Some would argue that the $624.86 could be considered wasted; others would say that succeeding more quickly was just the boost Taylor may have needed to stay on track. Regardless of the approach, the goal is the same: eliminating debt. Both methods are designed to accomplish this. The important thing is to pick the approach that works best for you, make a plan, and stick to it!

    Impact of Debt on a Financial Plan

    (Stephens & ChatGPT, 2024)

    Debt plays a pivotal role in shaping your overall financial plan, influencing both short-term and long-term financial goals. On the positive side, carefully using debt can facilitate major life milestones, such as purchasing a home or funding education, which might otherwise be challenging to achieve with cash alone. However, the impact of debt extends beyond the immediate benefits, as it introduces a layer of financial responsibility and obligation that must be carefully managed. The type of debt, interest rates, and repayment terms all contribute to the overall financial landscape, requiring you to strike a delicate balance between using debt for necessary investments and avoiding excessive financial strain.

    The burden of debt can shape the trajectory of your financial future. Excessive or high-interest debt can limit your budget, hindering the ability to save for emergencies, invest in wealth-building opportunities, or contribute to long-term retirement goals. The interest payments on debt represent a continuous outflow of funds that could otherwise be allocated to wealth accumulation or other financial priorities. As such, effective debt management becomes integral to a financial plan, necessitating a thoughtful approach to borrowing, regular assessment of debt levels, and adjustments to ensure that debt aligns with broader financial objectives rather than serving as a hindrance to your financial well-being.

    Prayerful Consideration

    Debt can be a great thing or a terrible danger depending on your situation. As you prayerfully consider how these principles can best be applied to your unique situation, pray for guidance on what approach will help you best pay off any debts you currently have. Pray for guidance on what debt you should be taking on.

    References

    Ashton, M. J. (1981, October). “Give with Wisdom That They May Receive with Dignity.” General Conference. https://www.churchofjesuschrist.org/study/general-conference/1981/10/give-with-wisdom-that-they-may-receive-with-dignity?lang=eng#:~:text=me%3F%E2%80%9D%20Can%20you%20quietly%20sit%20down%2C%20review%20the%20facts%2C%20and%20list%20all%20the%20possible%20courses%20of%20action%3F%20Can%20you%20identify%20causes%20and%20determine%20remedies%3F%20Quiet%20contemplation%20can%20solve%20problems%20more%20quickly%20than%20frantic%20force.

    ChatGPT (Version 3). (2024). [AI]. Open AI. https://chat.openai.com/auth/login

    Consumer Financial Protection Bureau. (2016, August 16). What is the difference between fixed- and variable-rate auto financing? [Government]. Consumer Finance.Gov. https://www.consumerfinance.gov/ask-cfpb/what-is-the-difference-between-fixed-and-variable-rate-auto-financing-en-757/

    Consumer Financial Protection Bureau. (2024). An essential guide to building an emergency fund [Government]. Consumer Finance.Gov. https://www.consumerfinance.gov/an-essential-guide-to-building-an-emergency-fund/

    FINRA. (2014). Money Math for Teens. Debt Elimination: Power Tools for Building Wealth.

    Hinckley, G. B. (1992, March 1). This I Believe. Devotional. https://speeches.byu.edu/talks/gordon-b-hinckley/believe-2/#:~:text=Reasonable%20debt%20for%20the%20purchase%20of%20an%20affordable%20home%20and%20perhaps%20for%20a%20few%20other%20necessary%20things%20is%20acceptable.%20But%20from%20where%20I%20sit%2C%20I%20see%20in%20a%20very%20vivid%20way%20the%20terrible%20tragedies%20of%20many%20who%20have%20gone%20on%20a%20binge%20of%20borrowing%20for%20things%20they%20really%20do%20not%20need.

    The Church of Jesus Christ of Latter-day Saints. (2017). Learn—Maximum Time: 45 Minutes. In Personal Finances for Self-Reliance. https://www.churchofjesuschrist.org/manual/personal-finances-for-self-reliance/9-managing-financial-crises/learn-maximum-time-45-minutes?lang=eng

    W03 Case Study: Eliminating Debt

    This content is provided to you freely by BYU-I Books.

    Access it online or download it at https://books.byui.edu/fcs_340_readings/chapter_3_debt.