When it comes to the right strategy to pay off debt, you’ll get a passionate debate on the best way to do so. My opinion: Whatever works for you! I know that doesn’t seem like a good answer from a CERTIFIED FINANCIAL PLANNERTM professional, but ultimately paying off debt must be a personal decision. You must own the process, and you must be accountable to yourself along the way. Often in finances, the right decision based on math may not be the right decision based on human emotions, which always plays a role!
I’ll break down the two most common methods to paying down debt and the pros and cons of each of them through the below illustration:
Debt Type | Loan Balance | Minimum Monthly Payment | Interest Rate |
Car Loan | $5,000 | $350 | 5% |
Student Loan | $30,000 | $150 | 3.5% |
Medical Bill | $1,500 | $20 | 8% |
Credit Card | $9,000 | $25 | 12% |
Total Minimum Monthly Payment = $545
Total Monthly Income Available to Pay Down Debt = $750
Debt Snowball
The debt snowball does not consider the interest rate of each loan. Rather, it focuses on making the minimum payment on all loans with the exception of the smallest loan balance. For this loan, you will put together all extra monies to pay it down rapidly. Once the smallest loan is fully paid off, you then allocate those monies to the next smallest loan. In the example, you start with the Medical Bill by paying $225 per month ($750 allocated to paying debt each month - $525 minimum payments) until it’s fully paid off (about 7 months). You then take that money and put it towards paying off the next smallest debt, which is the Car Loan. You then continue to pay down debt from smallest to largest based on balance.
The debt snowball is all about seeing progress. It doesn’t consider the fact that you’ll be paying more in interest on some of the higher loan balances. This method is not the right answer when it comes to math, but it can be the right method when human emotions are involved. It’s the right method If you see a pile of debt and are discouraged because you aren’t making much traction. There’s a human need to be rewarded and to see something positive happening through small victories.
Highest Interest First
The highest interest first method is straightforward. Order the debts from highest interest to lowest and pay off the highest first, while making the minimum payments on the others. In the example, you’d attack the Credit Card debt first, making payments of $230 until it’s fully paid off. From there, you identify the next highest rate and pay that down with the additional monies.
The highest interest first way is the mathematically correct method. It can however take a long time in order to experience victory and see things happening, which may not help the emotional side of tackling debt.
I’ve recommended both methods to clients in the past based on their specific situation and their personality. You have to be able to relate to the method chosen based on your emotions and on mathematical realities. If you have a hard time (mentally) paying only the minimum on the Credit Card while paying down something else first, then go with the highest interest first approach. If you like seeing debts get paid off completely, those smaller and faster victories, then the debt snowball will suit you.
Ultimately, there needs to be an honest assessment on how and why you got into debt in the first place. Everyone’s situation is different, but if there’s not a conscious effort to change the decision making and actions that got you into debt in the first place, it’s likely that you’ll start the process all over again. Getting out of debt and then staying out of debt is like losing weight through dieting and then keeping the weight off. A change of behavior must occur to be successful. It may mean cutting up credit cards, finding a way to make more money, spending less on a vehicle, figuring out where your money goes each month, etc.
Finally, anyone who has been in debt can relate to the bible verse from Proverbs 22:7, “The borrower is servant to the lender.” When a loan is paid off, there’s relief of a heavy weight lifted; a burden that’s been removed once you’re debt free. So regardless of the method you choose, just get started!
If you’ve overcome significant debt, I’d love to hear about it! Email me at Christopher.Hull@CeteraInvestors.com or call me at (716) 707-1818.