The Best Way to Pay Off Debt
Time Magazine listed "Get out of debt and save money" as the resolution most commonly broken!
How can that be? My guess is that people simply don't have a good plan for actually getting out of debt. It sounds like a good idea and one you may really want to accomplish, but how exactly should you go about it? What's the best strategy?
If you were to ask my husband the best way to pay off debt he will tell you, "With money. Boom." Unfortunately, it's not that simple and requires a much longer answer!
Popular Strategies include:
1. The Avalanche Approach - Using this approach, you put your debts in order of interest rates and pay the one with the highest interest rate first. This strategy results in the lowest total interest paid and is the preferred method by popular author, TV and radio host Suze Orman.
2. The Snowball Approach - If you choose this option, list your debts in order of overall balance and pay the credit card with the lowest balance first, ignoring interest rates. The main benefit of this approach is the "immediate gratification" one receives when a debt is paid off quickly. This method has been around forever but it's been made popular by author, TV and radio host Dave Ramsey.
These methods are perfect for some people yet totally wrong for others. They look at the interest rate or balance of your debts while failing to look at other components.
Other Important Factors:
1. The Payment Amounts: If you owe $2,500 on a credit card at 15% and $2,600 on a car loan at 5%, both the Avalanche and Snowball approaches would say you payoff the credit card first. However, your monthly payment on the car is likely much higher which means even without making any extra payments, you're chipping away at the balance on the car at a faster rate. Therefore, it may make sense to throw extra money to the car instead of the credit card. Plus, wouldn't it be nice to free up the monthly car payment going forward? If the car is paid off first, you now have more money to pay toward the credit card which tackles the credit card much even quicker.
2. Your Emotions: Have you ever owed a friend or family member money? If so, then you know better than anyone the interest rate, balance, or payment amount don't really matter. The emotional "baggage" of these may mean they should be paid first even if it doesn't make sense "mathematically."
3. Your Own Determination to Succeed: Some of my clients are so frustrated, disappointed or just plain sick of being in debt they're going to pay it off no matter what gets in their way. If that's the case, the Snowball approach may not be necessary because you don't need "immediate gratification" and you're likely to pay less in interest by paying off a debt with a higher interest rate first.
4. The Tax Consequences: If one of the debts in your list is a student loan, you may be deducting the interest on your tax return each year (discuss this with your accountant). When ranking your debts in order of interest rates, this is something to consider. If the interest rate on your student loan is 6.5% yet you deduct the interest you pay, then your actual interest rate is slightly lower. You may need to change your rankings accordingly if another debt is also listed as 6.5% but without a deduction for the interest.
What's the Best Debt Payoff Strategy?
The best approach to paying off debt is one that is completely customized to you and your situation. If debt payoff is your goal, I take all of the above factors into consideration. I show you the good, the bad, and the ugly of each strategy. I show you how the time-line changes or the total interest changes with each approach. I can even project certain milestones such as when one debt will be gone using one strategy versus another. The order you payoff your debts may result in differences that are considered insignificant such as $20 in total interest or a one-month payoff time-frame. Wouldn't you want to know that? An analysis such as this is part of the service I provide to my clients. We'll discuss it at a future appointment if we haven't already.
All this information is key to helping you choose the strategy that's best for you. Feeling confident in your debt payoff strategy means you're more likely to succeed. You'll be unwavering and optimistic in your mission!
What's the 2nd Best Debt Payoff Strategy?
The next best approach to paying off your debt is simply one that you stick to until your goal is accomplished. This idea "divide and conquer" doesn't really work when it comes to debt- if you divide your extra payments among all of them, you end up not really conquering anything. Choose a debt, whether it's the one with the highest interest rate, lowest balance, most emotional baggage, or biggest payment...just pick one, pay the minimums on the rest and throw everything extra to the debt you chose. Again, pick a debt, tackle it until it's completely gone, then move onto the next one. Try to resist the urge to choose one strategy, do it for a little while, then change because you read an article or talked to a friend who said to do it differently. Consistency is key and do not try to divide and conquer!
At Fiscal Fitness, our goal is simple- to take the stress out of money. Every day we’re empowering individuals and couples to change how they spend and save their money. I hope this article provided you with some ideas for tackling your debt in 2013!
Call TODAY to schedule an appointment - (480)788-4588!