Debt Management Strategies

Debt management is one of the most impactful areas of financial planning. The average American household carries approximately $105,000 in total debt, with total U.S. household debt reaching a record $18.59 trillion as of Q3 2025. Credit card debt alone hit a record $1.233 trillion. For CFP professionals, helping clients understand and optimize their debt can free up cash flow for savings, reduce stress, and accelerate wealth building.

Good Debt vs. Bad Debt

Not all debt is created equal. Financial planners distinguish between good debt (productive debt) and bad debt (destructive debt) based on several key factors.

Good Debt Characteristics:

• Finances an appreciating asset (home, education, business)
• May be tax-deductible (mortgage interest, student loan interest up to $2,500)
• Typically has lower interest rates (3-8%)
• Creates long-term value that exceeds the cost of borrowing
• Has structured repayment terms with fixed end dates

Bad Debt Characteristics:

• Finances depreciating assets or consumption (cars, vacations, everyday expenses)
• Not tax-deductible
• Usually has high interest rates (15-30%)
• Provides no lasting value once consumed
• Often has minimum payments designed to maximize lender profits

Important Nuance: Even "good debt" becomes bad debt if the amount borrowed exceeds the value created. A $200,000 student loan for a degree that leads to a $40,000 salary may not be "good debt" despite the category.

The True Cost of Debt

Many consumers focus only on monthly payments without understanding total interest costs. CFP professionals must help clients see the full picture.

Example: Credit Card Debt

• Balance: $10,000
• Interest Rate: 22% APR
• Minimum Payment: 2% of balance ($200 initially)

If paying only minimum payments:

• Time to pay off: 30+ years
• Total interest paid: $19,000+
• Total cost: $29,000+ for $10,000 in purchases

Example: 30-Year Mortgage

• Loan Amount: $400,000
• Interest Rate: 6.5%
• Monthly Payment: $2,528 (principal and interest)
• Total payments over 30 years: $910,080
• Total interest paid: $510,080

This is why the CFP exam emphasizes understanding amortization schedules and the impact of extra principal payments.

Debt Avalanche vs. Debt Snowball

When clients have multiple debts, two primary payoff strategies dominate financial planning discussions. The CFP exam frequently tests the differences between these approaches.

Debt Avalanche Example:

Client has three debts:

1. Credit Card A: $5,000 at 24% APR
2. Credit Card B: $8,000 at 18% APR
3. Personal Loan: $12,000 at 10% APR

Avalanche order: Pay minimums on all, put extra money toward Credit Card A (highest rate), then B, then the personal loan.

Debt Snowball Example:

Same debts, but Snowball order: Pay minimums on all, put extra toward Credit Card A (smallest balance), then B, then the personal loan.

Research Note: While the avalanche method saves the most money mathematically, studies show that people using the snowball method are more likely to actually eliminate their debt because the psychological wins from paying off accounts keep them motivated. A CFP professional should consider client personality when recommending a strategy.

Refinancing Strategies

Refinancing involves replacing an existing loan with a new loan, typically at better terms. Common reasons to refinance include:

1. Lower interest rate - Reduces monthly payment and total interest
2. Shorter loan term - Pays off debt faster, saves interest
3. Cash-out refinancing - Access home equity for other purposes
4. Consolidate debts - Combine multiple debts into one payment
5. Remove PMI - Refinance once equity reaches 20%

The 0.75% Rule: A common guideline suggests refinancing makes sense when you can reduce your rate by at least 0.75% (some say 1%). However, the true analysis requires a break-even calculation.

Refinancing Break-Even Analysis:

Break-Even (months) = Closing Costs / Monthly Savings

Example:

• Current mortgage: $300,000 at 7.5%, payment = $2,098
• New mortgage: $300,000 at 6.5%, payment = $1,896
• Monthly savings: $202
• Closing costs: $6,000
• Break-even: $6,000 / $202 = 30 months

If the client plans to stay in the home more than 30 months, refinancing makes sense.

2025-2026 Refinancing Environment:

With mortgage rates averaging 6.5-7.0% in late 2025, homeowners who purchased during the 2022-2023 rate spike (when rates briefly exceeded 7.5%) may find refinancing opportunities. However, those who locked in rates below 4% during 2020-2021 should generally keep their existing mortgages.

Debt-to-Income Ratios

Lenders and financial planners use debt-to-income (DTI) ratios to assess borrowing capacity and financial health.

Front-End DTI (Housing Ratio):

• Housing costs / Gross monthly income
• Target: 28% or less

Back-End DTI (Total Debt Ratio):

• All debt payments / Gross monthly income
• Target: 36% or less (some lenders allow up to 43% for qualified mortgages)