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Which Debts Should You Pay Off First, and How
Life happens to all of us. Possibly you simply finished school, or just got moved in with someone to a new apartment. Maybe you purchased a home or had some startling costs, or it could even be that life just happened and you are up to your neck in paying off creditors.
You continue on letting life happen and you take out a 2nd mortgage or advances on charge cards, or maybe even payday loan, and now you need to figure out where to start to pay it down. There are a number of schools of thought on how to tackle your debts and but in the end they really boil down to two methods that have been successful, paying down the highest interest rate debts or the snowball methods focusing on the smallest balance first. We are going to look at both and then you can take the approach you feel fits you.
Concentrating on High Interest Balances First
Suppose you have an extra $200 a month to put towards debt reduction. You could pay it on the vehicle advance that you are paying 4% on or you could pay it on the charge card that you are paying 18% on. The choice between the two actually should be quite obvious, pay off the higher rate credit card first because that is actually costing you more money. Over the life of the debt you will pay more for the credit card debt then the car.
For a few, seeing those numbers is everything necessary to settle on the choice to consistently make additional payments to the credit card.
When you are choosing which debt to pay off first this simple approach is a logical choice, Pay off the expensive money first. The example above may only be a subset of all of you debts so it is time to make an investment of time in yourself. Write down all of your debts and their associated interest rates. Next we need to rewrite them so that the highest interest rate debt is first, then the 2nd highest, and 3rd highest and so on. The only exception to this will be if the interest is tax deductible. For most of us this will only be a mortgage and this hopefully is a much lower rate than our other debts. In the event the choice is between a tax deductible interest and not it is best to discuss it with a tax professional to determine how you will be affected.
Once you have your list don’t panic. Take a deep breath. Know you are doing something to alleviate the burden. Next, take all of the extra money you can, based on your budget, and start paying extra payments towards the highest interest rate debt. In some circumstances, like a mortgage or car loan, you will want to make sure that extra money goes towards principal only. If you don’t the money’s just put towards future payment which include interest charges. You will continue to make the extra payments until that debt has been completely paid off. Then you will get out your list of debts in order of highest interest rate to lowest and cross out the first debt. Next have a 5 minute party, do a happy dance, and start on the 2nd lowest. You are going to make the extra payments the same way with one difference, the actual payment for the first debt is now going to be included in the extra payments for the 2nd debt. For example, the first debt you just paid off had a monthly payment of $200 a month and you make an extra payment each month of $100, a total of $300. The next debt on your list has a payment of $120 per month. We are going to take the $300 per month we paid to the first debt and make that our extra monthly payment. By doing this we are accelerating the debt reduction process.
You will continue this process of extra payments until all of the debts on your list are gone.
Lowest Balance First
This is my favorite method of the two and it is for one simple reason, it’s all in your head. The biggest problem we all face with a large debt burden is the feeling of helplessness. As if the weight of the debt has pushed us down so far, and holding us down, that we will never get us. Never get out from the weight of our debt. This method tricks our brain and that feeling of helplessness will go away rather quickly.
The major difference between the 2 methods comes down to the order we choose to pay down our debts. In the approach above we look our debts from a logical standpoint, the cost of money. It makes sense and will save you money in the long run. With the Snowball Method we are going to bypass logic and go for gratification.
Here is the simple plan you are going to follow, list out your debts in order of the lowest balance first, then 2nd lowest, then 3rd, and so on. We are not going to list the payment or the interest rate, only the balance. Each month we are going to make our regular payment and we are also going to make the extra payment. If the first debt is only $800 you will pay it down in about 4 months, depending on the terms and interest rate. 4 months to have that debt off our backs. 4 months to a victory. That is why I prefer this method, you get a win very quickly, and for most of us who are starting this debt repayment journey, we really need a win. Once the first one is paid off you are going to take that payment and the extra payment and attack the 2nd lowest balance debt on our list. Odds are this one will go by quickly as well and we will have a 2nd victory.
That is the beauty of this approach is the victories. If using the highest interest rate method our first debt is $8,000 it could take a year, or 2, to pay this debt off. Paying off a low balance may not seem fiscally responsible, but who cares. You are the one who has been carrying the weight of the debts and you deserve to feel good about yourself. You deserve to feel like you accomplished something. That victory of paying off the small balance can propel you into more and more debt reduction at an accelerated pace.
Which is Best?
Which method is best comes down to which is best for you. This will take some thought but it is worth the effort to start the process. That process starts with a budget so you can determine how much you can put towards your debt reduction efforts. Our recent article explaining why you should have a budget to save money is a good place to start. You can read that article here.
One other things to keep in mind, your attitude will be the biggest determining factor in your success. If you follow one of these methods, are true to yourself and disciplined in your approach you will succeed.