photo credit: kivanc

Recently, we covered step 1 on how to get out of debt - stopping the bleeding, or preventing the accrual of additional new debt. Preventing added debt is essential when trying to break free of debt, however, you’re still going to be in the red unless you find a way that works for you to strategically fill the hole that you’ve already put yourself in. Without having a plan of attack, the length of time it takes you to pay off your debts will be magnified. Let’s discuss some of the current schools of thought out there, so that you can develop the best strategy for you to wipe out your debt.

Debt Payoff Strategies

In the previous ‘get out of debt’ article, I introduced a debt planner spreadsheet. In order to illustrate some of the following strategies, you may want to open this sheet and record all of your debts.

Debt Planner Spreadsheet (google doc - feel free to copy and save your own editable version)

debt-planner-spreadsheet1 (.xls/.ods)

Strategy 1: High Interest Debt Payoff Method

This method is essentially attacking your highest interest debts first. When followed with discipline, it should lead to you paying the least amount in interest. Here’s how it works:

1. List your debts, in descending order by interest rate, regardless of how much each debt is.
2. Pay off all minimum amounts for each payment period for each debt.
3. Apply all available income towards the highest interest debt.
4. The more you can apply towards high interest debts, versus low, the more money you are saving. This savings will allow you to pay off your debt faster.
5. Once your highest interest debt is paid off in full, move on to the next highest interest debt and work your way down to the lowest.

Let’s suppose that after figuring out your monthly budget, you had $1,600 that you were going to apply towards debt pay off, but only needed to pay $1,200 in minimum payments. Here is what the high interest debt payoff method would look like:

Notice that the monthly minimum is the same as the actual payment for all but ‘Credit Card 1′, with all $400 of the remaining non-minimum amount budgeted going towards paying off this debt, which has the highest interest rate. After this debt is paid off, you would then move to ‘Credit Card 2′ and so on, down the list.

Strategy 2: Smallest Payment First Debt Snowball Method

The debt snowball method, championed (if not invented) by Dave Ramsey, is to stop everything except your minimum payments and focus on the smallest debt that you have to pay it off quickly, and then gradually building your way up to the largest. Here’s how it works in theory:

1. List your debts in ascending order with the smallest balance first, ascending to the highest balance debt amount.
2. Pay off all minimum amounts for each payment period for each debt.
3. Pay off your smallest debt, which should also be the one that you can pay off first.
4. After your smallest debt is paid off, move on up in order from smallest to largest.
   
5. In theory, getting rid of small debts quick builds up ‘momentum’ to encourage you to stay interested in getting rid of debt. Ramsey claims that getting out of debt is more emotional and psychological than rational. This is the ‘debt snowball’ that Ramsey speaks of.

Again, let’s suppose you have the same $1,600 to work with, and $400 can go towards non-minimums. Let’s see how this would look with Ramsey’s debt snowball method:

Here, you can see that the debt which has the additional $400 applied towards the principle amount remaining is the ‘Auto Loan’, which has the lowest amount remaining at $4,000. After ‘Auto Loan’ is paid off, you would then move to ‘Credit Card 1′.

Strategy 3: Consolidation Payment Method

I’m hesitant to bring this third strategy into play, but it is an ‘option’ on the minds of many, so it should be addressed. This method is a way for you to ‘lump’ all of your debts into one large debt that you can focus on, usually with a high interest. Debt consolidation is a huge, and many times, shady, industry. The promise is that you will be able to combine all of your debt into one low interest payment loan. Although, this is ideal, it is very rare that you’re going to find a silver bullet here.

If you have enough bad debt to have a need for consolidation, then your credit is not going to be the best. This means that you’re most likely going to get a higher interest rate, or pay a ton in fees (both hidden and transparent) and/or insurance in the event of default. Additionally debt consolidators have been known to be late, or miss paying your creditors altogether. Debt consolidation is a way for you to pay one amount at best, and a way for you to default on your debts or end up paying more in the long run at its worst. Be vary careful before heading down this road.

The one way that this method might pay off is if you already have a fixed rate home equity loan with a respectable interest rate. If this is the case, you can use your equity to pay off high interest credit card debt (and close those cards).

Best Strategy?

Really, it all depends on what your priorities are. If your goal is to pay the least amount possible and you are disciplined in your approach, your best bet is probably the high interest first debt payoff method. If your interest and motivation in paying off your debts is less than stellar, then the lowest payment first debt snowball method may be your best bet. Perhaps you can combine the two, paying off very low balance debts right away before tackling high interest debts in descending order (by rate).

Question for the Readers

What kind of debt payoff strategy are you currently using? How has it motivated or unmotivated you?

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