In my previous post, I mentioned that I would discuss some methods for determining what your sweet spot is for balancing getting out of debt with living your life. Today I will be discussing one such method that I like to call “debt pricing”. The nice thing about this method is that it takes very little work to setup and gives you a nice rule of thumb as you make your financial decisions on a daily basis.
We all go through our days making a myriad of seemingly mundane choices that when considered over time can have serious impact on our financial situation. Some examples include getting Starbucks coffee in the morning vs making your own coffee, buying lunch vs packing a lunch, and so on. We all encounter various situations like this through our daily lives and have learned to make value judgments to decide how we are going to spend our money in these situations. Some of these choices are habit based, like a caffeine addiction, and others are made around convenience. The debt pricing method allows you to quickly add the impact your purchase decisions will have on your debt with some quick mental math so it is convenient to consider.
Lets work through a quick example to see how this method actually works. The debt pricing method relies on computing a debt multiplier. It is the amount by which one extra payment in the next year will reduce the overall cost of the debt. So the method takes your current payment amount and considers what your total payment will be for the loan if you paid just 1 extra payment of your regular amount 6 months from now (the mid point of the next year).
If there are enough requests for a tool that can let you calculate this multiplier simply, I will build and share one. For now, you’ll have to trust the numbers I’m discussing in this example – or as an academic would say: left as an exercise for you to verify.
Lets say you are a fresh graduate with $100,000 in student loans at 6% interest for a term of 25 years. In this case, your monthly payment would be 644.30 assuming traditional monthly compounding loan interest and not the peculiar student loan interest calculation the government uses (a topic for another post!). Over 25 years, the total amount of payment for this loan would total $193,934.72. If you paid one extra payment of $644.30 six months from now, your overall total payment for this loan would drop to $191,166.01 for a savings of $2,768.72. The debt multiplier would then be calculated as the total savings divided by the extra payment, or 4.3 (4.3 = 2,768.72 / 644.30).
The way to interpret this multiplier is that on average over the next year, every extra dollar you put into the loan will save you $4.30 over the life of the loan! You can then use this multiplier to quickly consider the cost of your debt in purchasing decisions.
If a hypothetical person with no debt is trying to decide to buy Starbucks coffee for $5.00 vs making their own for $1.00, that person would have to decide if the Starbucks represents $4.00 in additional value vs the home made coffee. The person with the $100,000 debt in the example above shouldn’t be considering the $4.00 difference, but the $4.00 multiplied by the debt multiplier of 4.3, or $17.20. Perhaps on really tough days, that Starbucks coffee will be worth it for the debt laden person and on other days not so much. Hopefully the debt pricing method doesn’t remove Starbucks coffee forever from this person’s lifestyle, but perhaps modifies the behavior to a less frequent level that naturally balances towards this sweet spot of balancing paying off debt and indulging in other activities.
The nice thing about this method is that once you have calculated the multiplier, it is easy to apply in daily life without some overly complicated system or have a lot of administrative over head of keeping on top of budgets and tracking expenses. All it does is ask you to develop a habit of applying the multiplier in your daily purchase decisions to help you decide if those things are really worth it to you.
Another nice property is that you can recalculate the multiplier annually. As you work on paying off your debt over the year, the multiplier will naturally lower. This is due to several reasons including that there is less term left on the loan and less time for your extra payments to save you interest and the fact that each additional dollar of pre-payment saves a little bit less interest. So if you pay off more of the loan in the coming year, you will be rewarded in a sense with a lower multiplier the next year. This will allow you to gradually increase the amount of money you would like to spend on other things besides debt over time, making it more manageable.
What do you think about the debt pricing method? Let me know your thoughts in the comments.
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