Buckling down and paying off debt is a great financial task to commit to, but it’s not as easy as just sending in a few payments every month. After all, not all debt is created equal and, for the sake of saving money and reaching debt freedom a little bit faster, it’s best to be strategic about which debt you tackle first.
Here’s the Deal:
The first step to paying off debt is to get a handle on your debt situation.
When you’re buried under mountains of debt, it can be hard to keep a mental tally of every type of debt you have as well as the details of each account.
Compile a list of every single type of debt you have along with the following information:
- Total amount owed
- Interest rate
- Loan term (if applicable)
Understand the difference between “good” and “bad” debt
Debt is debt and, when given the option, should be avoided. But for the sake of this exercise, it’s important to understand the difference between what is considered “bad” debt and what is considered “good” debt.
Mortgages and student loans are usually considered “good” debt because the interest is often tax deductible and the interest rates are likely lower than other types of debt. In addition, this is the type of debt that will increase your net worth – owning a home is an asset and a college education can increase the amount you earn throughout your lifetime.
Credit cards, on the other hand, are considered “bad” debt because they often carry high interest rates and fees that keep the consumer in a never-ending debt cycle. Car loans are also considered “bad” debt because cars depreciate quickly, making it easy to owe more than the car is actually worth.
How can you actually use this?
- Determine which categories your debt falls into and look closely at the rates and balances of your debt. “Bad” debt should be addressed first as its less-than-optimal terms and negative pressures only add to your less-than-ideal financial situation.
- Consider: What are the interest rates and balances on each of these accounts? Organize them in order, from lowest to highest, in terms of both interest rates and balances. There are two schools of thought in regards to which of these to tackle first. Some say it’s best to aggressively pay down the account with the highest interest rate first because that is accumulating additional charges at the fastest rate and, once gone, would provide the biggest boost to your financial situation. Others believe you should get rid of the account with the lowest balance first because that would provide the biggest mental boost in the debt payoff process. In other words, seeing one account with a zero balance will give you the motivation to keep going.
Decide which makes the most sense to you. After all, what works for one person might not work for someone else.
What if you can’t afford all of your debt payments?
Being able to afford all of your debt payments but simply wanting to speed up the payoff process is quite different than struggling to simply make all the minimum payments. If the latter sounds more like your situation, you might need to adjust how you pay down your debt.
The debt you carry is either secured or unsecured. Secured debt carries with it some type of collateral. For example your mortgage and car loan are considered secured debt because if you default on your payments, the lender can essentially take away your house or your car.
Therefore, if you are in a rocky financial situation, it’s best to ensure you stay current on your secured debt payments.
Which Debt to Pay Off First? (Lowest Balance vs. High Interest)
The question of which credit cards should you pay off first, lowest balance or highest interest rate will get most personal finance enthusiast super excited, but for everyday people struggling with debt, they just want help. I wish there was a simple answer on which method will help them get out of debt the quickest and easiest way. It may come down to personal choice, and personal situation. They don’t call it personal finance for nothing. Let’s look at the Debt Avalanche and Debt Snowball methods for a better understanding.
Debt Avalanche (Highest Interest Credit Cards)
The Debt Avalanche is a method of repaying debts in which you pay the debt with the highest interest rate first. All other debts continue to get minimum payments during the process. Once the highest interest rate debt is paid off you move to the debt with the second highest interest rate, applying the payment from the highest interest rate debt to the second. The process is repeated until all debts are paid. From a mathematical standpoint this will save you money on interest costs. It is appropriately named the “Avalanche” because you start from the top and work down, like an avalanche of snow falling down a mountain. Keep in mind if interest rates on your debts are the same or about equal there is no real benefit to this method.
One challenge with this method is that interest rates on credit cards are subject to change. You may spend ten months attacking that 21.99% Home Depot account and then your introductory rate on your Chase account jumps to 24%. Your initial plan is derailed and momentum is lost. Changing your focus half way through the process can be frustrating.
Debt Snowball (Lowest Balance Credit Cards)
The Debt Snowball is a method of repaying debts in which you pay the debt with the smallest balances first. All other debts continue to get minimum payments during the process. Once the smallest debt is paid off, you move on to the next debt with the smallest balance just like in the avalanche method you take the payment from the first smallest debt and apply it to the payment of the second smallest debt. This method helps build momentum. Hopefully the smallest balance is small enough to quickly be paid off. This quick win should help motivate you to continue the process and move onto the next. Like a snowball rolling down a hill, as each debt gets paid off, you pick up more momentum, and more cash gets rolled over to the next debt.
As long as you committed to stop using your credit cards, you shouldn’t have to change gears with this method.
Building a Better Mouse Trap
To be successful using either one of these methods, it’s important to be organized with your money. Having a plan in the form of a budget is a great first step. The budget is your money blueprint, giving you the understanding of your income and expenses. Are there expenses that can be cut? Think about those things in your budget that you are spending money on each month. Are they a need or a want? If they are a want they could be cut for a period of time while you work you way out of debt. That extra money can be added to your avalanche or snowball payments to speed up the process of getting out of debt.
After reviewing your expenses, you need to ask yourself this, can I increase my income? Taking on overtime, side work, or even a part-time job for a period of time is another great way to jump start debt repayment. Now think of the momentum you will build if you combined cutting expenses and adding extra income. The most important thing to keep in mind with cutting expenses or taking on extra work is that they are temporary endeavors to reach your goal of being debt free.
Which Method is Better?
I’m not sure which method is better for you. The debt avalanche has a mathematical advantage while the debt snowball has an emotional one. It really depends on the type of debts you have, the interest rates and your personal situation. I like the method that gets you out of debt the fastest, reducing that burden and getting rid of the stress it causes. If you need help deciding, assistance is just a phone call or email away.