How to Pay off Debt
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 get rid of debt debt.
Debt Payoff Plans
In the previous 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)
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:
- List your debts, in descending order by interest rate, regardless of how much each debt is.
- Pay off all minimum amounts for each payment period for each debt.
- Apply all available income towards the highest interest debt.
- 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.
- 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 (aka The Dave Ramsey Debt Payoff 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:
- List your debts in ascending order with the smallest balance first, ascending to the highest balance debt amount.
- Pay off all minimum amounts for each payment period for each debt.
- Pay off your smallest debt, which should also be the one that you can pay off first.
- After your smallest debt is paid off, move on up in order from smallest to largest.
- 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: Debt 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).
What is the Best Debt Pay 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).
Get Rid of Debt Discussion
What kind of debt payoff strategy are you currently using? How has it motivated or unmotivated you?
I’m not a finace afficiando, but I know of someone who had high-interest debt, got a loan from his bank with a lower interest, paid of the high interest, and now makes loan payments.
I don’t have any bad debt (yet) so I guess that makes me somewhat of an afficiando. But then again I live with roomates and drive a shitty car, so there’s the trade-off :).
Links to the google document and xls/odt are no longer working.
@ Daniel. Thanks for the heads up. Should be fixed now.
There are many ways that people can steal our identity. One, many people don’t own a shredder. Use it. And second, be carefull about who and where you place your information.
there have always been three ways of clearing debt:
1. repay it
2. inflate it away, or let the Government do it for you
I once read as book on international debt which stated “1” was by far the most common. Russians and various African and American countries/states apparently used to be masters at this. Too much debt, time for a revolution.
Inflation used to be great but no more.
Default is now much easier with IVAs readily available on every high street and bankruptcy much less painful. With an IVA you can still stay in business and I know qualified accountants and solicitors who have gone this route and kept their practices running!! But it does not help your credit history.
But it you decide to repay then you only have two choices – earn more or spend less. But it can make a lot of difference how you apply these policies and you may find it useful to visit this web site – it is a US site but I found it quite useful.
Great article here.
About a year ago I started listening to Dave Ramsey after talking to a friend who had employed the snowball technique.
I got very motivated and got my snowball rolling. After about 7 months I had paid down $8000 in debt. I then spoke to another friend who used the highest-interest method and saw the value in it.
Exactly as is stated above if I had started with the highest-interest method first I don’t think I would be successful with my debt payoff currently. I was able to knock out those smaller amounts quickly and it gave myself the wins I needed to stay focused. It’s amazing to see the progress.
Now that I have a base model and have changed my spending habits I am going to save a lot more money paying off the high-interest amounts first.
As an update, in just 14 months I have paid down nearly $17,000 in debt. I still have a ways to go, but I know I will get their by using a combination of the two methods described.
Now I preach both to everyone I know!
Could someone explain me how Strategy 2 (snowball) can be better than Startegy 1 (highest interest first)? Using snowball method you’ll always pay more in interests and stay longer in debt!
Strategy 2 is the psychological strategy. Those who are more logical thinkers (majored in engineering, economics, etc.) will probably prefer Strategy 1 because it appeals to their way of thinking. Those who like to make to-do lists and derive satisfaction from checking items off as they are done, and probably those who think more abstractly (majored in philosophy, English, etc.) will find Strategy 2 more effective. These are probably the same kinds of people who tend to get themselves into debt to begin with because discipline logical types of people would naturally tend to make a budget and stick to it (of course, I’m generalizing… this is just food for thought).
I put myself in the latter category, so I’d follow Strategy 2. However, another good reason to consider this one is if you pay off a credit card to $0, that one is now available to you for a balance transfer, should it be offered. Then you can use it to pay down your highest interest debt. Even if you don’t get a transfer offer, paying off one debt ASAP gives you a little more leverage in negotiating with those other folks.
You want to get out of debt is noble, but you must do something to get there … wanted to write and will not serve. In part-time job is a great idea … Get your resume and network with people. But a part-time employment, again without action, it will not. You must set realistic goals and plan of approach. If your debts credit card, stop using it immediately. If you can not pay cash for something you really can not afford. You already know how interest works against you. Make a list of all your debts and expenses. You may need to give things or at least reduce. Put extra money on your debt and watch the debt reduction in a row. Because debt is the result of the decision, if all the decisions you have made the debt that you are wrong. It is time to regroup and focus. Your answer is not a thing but a combination of increased revenues and reduce costs.
Just learn how to manage your own finances and pay off debts without spending more money on another company who is supposed to do what people need to do for themselves.
You forgot to add something about the snowball method (which makes it a good alternative to the higher interest method) which is that as you pay off the smaller debts, that payment adds on to the next debt’s payment. To use the example that was given in the article, once the smallest debt (car loan @ $4k) is paid off with $500/mo., that $500 is ADDED ON to the first credit card payment, meaning that you’ll start to pay $550 on the credit card, instead of just $450 (the min + the extra $400 in your monthly budget.) After that’s paid off, the $550 is added on to the $75 payment on the second credit card, making that monthly payment $625. Your monthly budget will always stay the same with $1600 being allocated towards debt repayment, but it’s being applied to fewer and fewer debts as they’re paid off. The snowball method is literal in that the payments are getting added onto one another, and figurative in that the psychological boost of paying off smaller debts gets you motivated to keep going.
Thanks for the information of Debt Consolidation Payment Method. People want to be careful with the idea of Debt consolidation loans. It is very helpful for the people if they list there debts and try to manage in proper way. Debt Consolidation is danger if people don’t know the correct procedure how to manage money. If people know the proper procedure regarding managing money Debt Consolidation loan is very helpful.
I can only make minimum payments and am still in the red each month about -$100. I can’t wait to use the snowball debt when I get my first credit card debt knocked out. After that is paid (yes, I cut that card up!) I’m going to use it towards the next bill until that one is gone.