Step 5 of Effective Money Management: Redirect

Managing your finances can be overwhelming, but with a step-by-step approach, you can take control of your money. In our previous posts, we covered the first four steps of effective money management: Record, Reconcile, Recognize, and Retain. In this post, we'll discuss the fifth step: Redirect. This step focuses on paying off debt and investing in your future.

By following the first four steps of money management - record, reconcile, recognize, and retain - you have established a strong foundation for financial stability. You have a clear understanding of your income, expenses, and financial goals. You have implemented strategies to control your spending and increase your savings. While it may have taken time to get to where you are today, these steps have put you in a position to move on to the Redirect step.

The concept of "redirect" refers to paying off debt first, and then investing in short- and long-term investment vehicles, while always retaining your six month emergency reserve. By paying off debt and investing in your future, you are creating long-term financial security for yourself and your family. Keep in mind that the redirect step is a process, and it takes time and dedication to achieve your goals. But with discipline and consistency, you can successfully navigate this step and achieve financial freedom.

Before we start paying down debt we need to determine if you're actually in debt. If you've been using a balance sheet to track your Assets and Liabilities there is a simple formula to determine this.  Simply subtract your total liabilities from your total assets. If the result is positive your in a position of equity, if the result is negative your in a position of debt.

If you find that you're in a position of debt then now is the time to pay it off. When eliminating debts, or more accurately loans or liabilities, there are two popular methods that can be applied: the avalanche method and the snowball method.

Avalanche and Snowball Debt Acceleration Calculators

The avalanche method involves focusing all your extra income on paying off the debt with the highest interest rate first while only paying the the minimum due on other debts. This method can save you money on interest payments in the long run, but it may take longer to see progress or stay motivated.

For example, let's say you have three debts:

1. Credit Card A with a balance of $15,000 and an interest rate of 18%
2. Personal Loan B with a balance of $10,000 and an interest rate of 10%
3. Car Loan C with a balance of $20,000 and an interest rate of 5%

Let's also assume you've saved six months of expenses, totaling $24,000, in your emergency fund by being disciplined to the habit of paying yourself at least 10% of your income from each paycheck.

By using the avalanche method, you would focus on paying off the $15,000 debt first, then the $10,000 debt, and finally the $20,000 debt. You would continue the habit of saving at least 10% to your emergency fund, but redirect any amount over the $24,000 to the principle amount of your $15,000 loan. Once you've paid off the $15,000 loan, you would redirect it's minimum payment plus all funds over your $24,000 emergency fund to the next debt's principle balance.  This pattern will be repeated until all your loans have been repaid.

On the other hand, the snowball method involves paying off debts with the smallest balances first. This method can provide you with quick wins and a sense of accomplishment, which can motivate you to continue paying off your other debts.

Using the same example, if you use the snowball method, you would focus on paying off the $10,000 debt first, then the $15,000 debt, and finally the $20,000 debt.

It's important to note that the snowball method may not save you as much money on interest payments in the long run, but it can be a useful way to get started and to build momentum.

Whichever method you choose, remember to redirect the payments from the paid-off loan to the next loan's principle amount in addition to the funds you save above your emergency amount. If you need to use funds from your emergency savings, it is important that you pause your debt payment plan until you've replenish your emergency fund.

Tip 1: Optimizing your budget is a key factor in accelerating the debt repayment process. By cutting down on unnecessary expenses and reallocating those funds towards debt repayment, you'll see results much quicker. This can mean sacrificing some luxuries in the short term to achieve long-term financial stability.

Tip 2: Until you've developed strict budgeting habits and disciplined your spending I'd advise you to avoid consolidating multiple loans into one.  On the other hand, if you've become disciplined in applying all the steps we discussed then it may be wise to consolidate your higher interest debts into a low interest rate loan. You would then redirect all payments that you would have been required to pay on the individual loans, plus all extra funds over your emergency amount, to the principle of the new loan.

Tip 3: Loans compound interest each and every day. Therefore, make your principle payments as soon and as often as possible. In the beginning this may not appear to make a significate impact, but over time this can make a big difference in the amount of interest you'll pay to the bank.  

Avalanche and Snowball Debt Acceleration Calculators

While it's important to pay off debt, it's also important to invest for your future. It may be possible to do both at the same time, depending on your situation.

If you have high-interest debt, such as credit card debt, it's usually best to focus on paying off that debt first before investing. However, if you have low-interest loans, such as a mortgage or a student loan, you may be able to invest some of your extra income while still accelerating your monthly debt payments.

One approach to paying off debt while investing is to use one of the methods from above and then redirect the payments from the paid-off debt to your investments instead of your next loan. For example, if you were paying $300 per month toward a credit card debt that you have now paid off, you could redirect that $300 per month to your investments.

Another approach might include redirecting 80% of your available debt repayment funds towards a loan while redirecting the remaining 20% to an investment. As you pay off debt, gradually shift more of your available funds towards investing.

Once you've paid off all your loans or at least all your high interest loans, it's time to simply redirect all funds over an above those required to maintain your emergency fund to short and long term investments that you understand and feel comfortable investing your money.

In conclusion, redirecting your money to pay off debt and invest in your future is an important step in effective money management. Whether you choose the avalanche or snowball method to pay off your debt, it's important to remain focused and committed to your goals. And remember, paying off debt and investing are not mutually exclusive. By being smart with your money, you can achieve both.