Choosing a Debt Payoff Strategy
The Best Method of Reducing Debt that Meets Your Needs
Paying off debt is vital to both your financial and mental wellness. But when you look at those bills, you're not quite sure where to begin. Relax. You are not alone. Many people have faced debt head on and chopped it down to size – but it takes a strategy to succeed, along with some patience.
There are several approaches you can take, depending on your financial situation and personality traits. Here is one popular path, along with exceptions where you may want or need to change your approach.
- Stop the Bleeding – If you are spending more than you earn, that has to stop first. You can't pay down debt until you stop accumulating it. Review your budget (and make one if you don't have one), and prioritize your purchases until you find some surplus to work with. Understand the difference between "wants" and "needs." By paring down the wants to the bare minimum, you can stop the bleeding and begin to create a surplus each month.
- Summarize all Debts – Now that you have a surplus to work with, you have to decide the best place to apply it. No strategy will work if you don't have a true handle on the amount and types of debt you have. Paying whatever bill comes up next is not a strategy, because it ignores the types of debt and the consequences of paying, not paying, or paying ahead.
List all your debts along with their type and amount. What is the interest rate? Are they home or car payments that are building equity, credit card debts, or installment loan debts on items that can be repossessed (such as cars or furniture)? If you can put them in a spreadsheet form, it is easy to sort them.
- Deal with High Interest Debt First – For most people, the best strategy is to apply the entire surplus toward the debt with the highest interest rate and pay minimums on the remaining debt.
If you have taken out a payday loan, get rid of it first. Interest rates are typically sky high and compounded frequently. Next on the list is usually credit card debt, with interest rates in the 25-30% range or higher. "One of the greatest expenses we have in our life is the interest expense on debt," confirms Adam Carroll, the Chief Education Officer at National Financial Educators. "Every single percentage point that you can decrease means massive amounts in your savings and investments later on."
Generally, you should attack high interest rate debt first, regardless of the relative amount, because it will save you significant money in interest charges. One good reason not to is if you have a debt with worse consequences that you have to get under control – for example, being so far behind in child support payments that you could go to jail.
- Pay Smaller Debts Next – After you get the high interest debt under control, if there is no priority among the remaining debts, pay the debts in order from smallest to largest. Why do the smallest first? It feels good to completely pay off a debt and it builds psychological momentum to keep attacking the remaining debt. As millennial money expert Stefanie O'Connell says, "It's more of this psychological boost to finishing your debt repayment journey."
You can do this first instead of attacking high-interest rate debt if you are easily discouraged – but when you do attack the high interest debt, you will be doing it for a much longer time.
- Creatively Address Larger Debt Items – For debts of this nature – like a home or vehicle – you may want to consider whether selling the asset and downsizing is the best strategy. For example, you may be able to rid yourself of a car payment by trading the car in on a lesser model and applying the difference to other debts. Alternatively, downsizing your home might make sense. If you sell a larger home at a profit and buy (or rent) a smaller one, you can pay down other forms of debt with your profits. Moreover, if you have owned the home for more than a year, which is common, those profits are taxed at the lower "long-term capital gains" rate, rather than as ordinary income.
Whatever plan you choose, the important thing is that you make a plan – and then stick to it. It may seem daunting, but you can do it… just as others have done before you.