Your financial situation isn't hopeless
Your financial situation isn't hopeless
How to build savings and vanquish debt for good
I knew things were worse than ever when he had to sell his camera.
30 or so years after taking on significant student loan debt to attend an elite art college, he’s reached the limits of a debt-enabled life.
This is the position a good friend of mine recently found himself in. Just about every last dollar that doesn’t go toward his basic needs goes to meeting minimum payments across the 22 loans he’s obligated to.
He found the love of his life a couple years back, which is wonderful for his heart, but excruciating for his wallet. Without savings or a lender willing to extend much more credit, he now faces the terrible challenge of finding a way to pay for a wedding.
This is how a photographic virtuoso winds up selling his camera to pay for catering.
The psychology of failure
My friend didn’t get here overnight. He’s been aware of his money problems from the beginning and has made several earnest attempts to address them over the years.
Unfortunately, he never followed a plan that made sense for his situation, and with each failed attempt, his faith in ever getting out was further eroded.
As he gradually lost hope, avoidance and denial settled in, leading him to increasingly rely on debt to build and sustain a lifestyle he couldn’t afford.
While my friend’s case is extreme, it’s a clear example of how the psychology of failure can lead us into a downward spiral that feels impossible to escape.
As you’ll see shortly, there’s always a way out.
Why we fail to escape debt
It’s remarkably easy set ourselves up for failure when we choose the wrong plan to get out of debt. Here are four of the biggest reasons this happens:
Conflicting information - Guru A tells you that your top priority is to build a $1,000 emergency fund while Guru B says it’s paying off your highest interest credit card. The right choice isn’t obvious, especially if your financial self-confidence is low.
Generic advice - Setting aside $1,000 for an emergency fund might be a walk in the park for one person and the equivalent of summiting Everest to another. Your goals need to be appropriate to your situation to avoid biting off more than you can chew.
Not prioritizing security - A lot of advice encourages people to pay off debts or begin building investments while they’re still vulnerable to calamity. If you still have to pull out a credit card to replace the water heater, you shouldn’t be buying stocks.
Not taking psychology seriously - Getting out of debt requires consistency and belief above all. It’s hard to stick with a long term plan that lacks early wins, a satisfying sense of progress, and a clear set of achievable milestones.
Here’s a quick litmus test to figure out if you might be on the wrong plan:
Year after year, your debt never seems to go down
The only joy you get from money is spending it
There’s always something that wipes out progress and brings in new debt
You’ve tried everything and don’t know what to believe anymore
Another year goes by without saving for retirement
If any of those ring true for you, it’s understandable that somewhere, deep down inside, you feel that your situation is hopeless. I’m here to tell you it’s not.
Now let me show you why.
The way out
The key to getting out of debt is to have a well structured plan that meets you where you are, sets tailored goals, and builds your financial confidence along the way.
Prerequisite: Use and configure a budgeting app
All of the subsequent steps rely on you being able to track and plan your spending, which is exactly what budget apps are for. I explain how to set up your budget category groups here. I love and use YNAB.
Step 1: Figure out your Savings Capacity
This is the dollar figure you get by subtracting your Everyday, Debts, and Scheduled Spending expenses from your monthly income.
Savings Capacity is the true measure of your ability to save and pay down debt.
It serves as the engine that gets you from where you are to where you’re trying to go. It determines your savings rate and debt pay-down pace. I provide a deeper dive into it here.
Avoidance and denial evaporate the moment you know your Savings Capacity since you it tells, in an instant, whether you can truly afford the lifestyle you’ve been living.
Take flying an airplane as a metaphor for your financial journey, where the height of the plane represents your financial health. The goal is to fly high and avoid crashing into the ground.
Your Savings Capacity tells you if the plane is going up or down.
The greater your Saving Capacity, the steeper your climb
A Savings Capacity of 0 means you’re flying level
A negative Savings Capacity means you’re descending
Step 2: Fill your Rainy Day funds
Once you’ve determined your monthly Savings Capacity it’s time to aim it at building security and peace of mind. You do that by filling your Rainy Day funds.
This is the part of your budget dedicated to saving for the potential expenses you’re most immediately vulnerable to. Think emergency repairs and insurance deductibles. Yes, we’re building (some) savings before reducing debt.
We start here because each of these potential expenses is like stepping on a debt landmine: it forces you to reach for a credit card if you don’t have the cash to deal with it when it hits.
In terms of getting out of the debt hole, saving for these expenses in advance is how you stop digging.
Unlike saving for some arbitrary $1,000 emergency fund, each full Rainy Day bucket shows you exactly how saving made your life better. To the cent. It’s a potent and addictive measure of progress.
You’ll feel a sense of calm and security come over you the moment you start filling these buckets up.
You achieve Financial Resilience when the last Rainy Day Fund is full. Back to our airplane, this the altitude in which you’re no longer flying dangerously close to the ground.
Step 3: Pay off your high interest debt
Now that you’ve disarmed your personal minefield, it’s now time to channel your well-developed savings skill to hack away at your debts. This will feel even better than the last step.
Debt comes in two flavors: high interest and low interest. We start with the high interest debt first.
A debt’s interest rate is high when it’s larger than the national average 30-year fixed mortgage annual percentage rate, commonly known as the “30 year fix” rate.
This is the dividing line for what most people agree is ‘good, long term debt,’ and it changes with the US economy. It’s 7.5% as of this writing, and I use bankrate.com to determine what it is at any given time.
Use today’s 30 year fix rate to identify all of your high interest debts, then sort them by minimum payment, from smallest to largest. This is your debt ‘hit list’.
Start adding your monthly Savings Capacity to the minimum payment of the first loan on that list and watch it’s payoff date leap closer to present day. The math that explains how this works is fascinating.
When you pay off that first debt, the light at the end of the tunnel becomes visible. You now have real, indisputable evidence that it’s only a matter of time until you’ve picked off every last debt on your hit list. On top of that, you’ll be picking up the pace.
The dollars that used to go toward that first loan’s minimum payment now go to your Savings Capacity, thereby increasing it. Using this larger figure to pay down the second loan means that you're paying it off at a rate faster than the first. That’ll put a spring in your step.
This technique is commonly referred to as the debt snowball. An alternative technique exists, called the debt avalanche, where you first pay down the loan with the highest interest rate.
While it does save you a little more money in the end, the snowball prioritizes early wins and builds momentum sooner, which why I recommend it.
Step 4: Build your Emergency Reserve
With all your high interest debt eradicated, you’re now sailing on calm waters. This is the time to build your Emergency Reserve, the safety net that catches you if you lose your income.
To determine how big your Emergency Reserve should be, pick the number of months you’d want to give yourself to line up your next job. This is your Unemployment Runway.
The length of your runway is a highly personal choice that reflects your risk tolerance. Common wisdom suggests that it takes the newly unemployed anywhere from 3 to 9 months to find a job.
Once you know your runway length (in months), multiply it by your average monthly Lifestyle Expense figure. This is the sum of your Everyday, Debts, and Scheduled Spending, averaged over at least 3 months.
If the sight of math makes you queasy, don't worry, calculations like this are child’s play for budgeting apps. Without the high interest loans to bog you down, you’ll be surprised at how fast you can fill this final savings bucket.
Think of all you have going for you by this point: you know how to save, your Savings Capacity is at an all time high, and you’ve got a long track record of wins that prove you know what you’re doing.
Once you finish filling this last bucket, you’ve done it. You’ve reached Financial Serenity. You’re now immune to financial calamity, all of your wasteful debt is extinguished, and you could take a leave of absence from work without breaking a sweat.
In the airplane analogy, this is when you break through the clouds and hit cruise altitude.
Step 5: Pay down low interest debt (if you want)
From the rarefied air of Financial Serenity, you’ve got options for what to do next.
While there’s nothing wrong with paying off your mortgage early, or closing the book on your student loans, you may decide there are better things to do with your (now huge) Savings Capacity.
This is the time to consider investing in a stock portfolio or spending some of that hard fought Savings Capacity on fun things like vacations and toys.
You’ve worked hard to get to this point, and you’re now genuinely able to afford a higher cost lifestyle if that’s what you want to do. Unlike what life looked like back at Step 1, you’re fully in control.
Go forth
A budget, knowing a couple of key numbers, and creating a credible plan are all that separate you from the depths of financial despair to an exciting and outstanding future.
The benefits kick in the moment you step foot onto this path:
Avoidance and denial instantly evaporate when you know your Savings Capacity
Anxiety and fear give way to pride and self confidence as you fill your Rainy Day funds
By the time you you’re ready to tackle debt, you’re already unstoppable
You feel lighter with each month that passes by and you redefine your relationship to money as you go. You no longer have to spend money to derive joy from it.
The psychology of failure that trapped my friend for all those years can be escaped. All you need is the will and drive to get started.