Paying off debt can be a long journey depending on how much debt you have. It’s very easy to lose motivation and give up, especially when you have other financial goals competing for your limited resources. That’s why it’s crucial to create a plan for your debt repayment.
Organizing Your Debts
First and foremost, you will need to find the following information about all of your debts:
- Amount owed (balance)
- Minimum payment
- Interest rate / Annual Percentage Rate (APR)
- Due date of payment
This information can usually be found in the statements you receive by mail or online, as long as you have an account to access them.
If you’re unable to find this information easily, just contact your lender and ask them for the information. They should be able to look it up for you.
The two biggest pieces of information we will focus on are your balance and interest rates, so make sure to at least get these two pieces of information before proceeding. Having a budget in place may make things easier as well.
Prioritizing Your Debts by Interest Rate
This is known as the “debt snowball” method, and mathematically, it is the method that will save you the most money over the course of your debt repayment journey. Simply arrange your debts from highest interest rate to lowest interest rate.
By focusing on paying off your highest interest debt first, you will save more money because the interest that accrues on your accounts will decrease. Interest can be a very nasty factor in your debt repayment plan if you’re not careful.
For example, let’s say you have a $10,000 loan at a 7% interest rate, and you have 5 years to pay it off. The minimum monthly payment will be $198, but not all of that amount will go toward paying down the balance. Instead, about $58 of the first payment will go toward interest. That stings. Compare that to the last payment, where only one dollar goes toward interest.
Making extra payments means you eliminate interest faster so that more payments can go toward the principal. However, this method doesn’t focus on the psychological impact that debt can often have.
Prioritizing Your Debts by Balance
What if you arranged your debts from highest interest rate to lowest and found that your highest interest rate is also the debt you owe the most? That may seem discouraging, and you haven’t even started planning yet.
If that’s the case, and you’re looking at a mountain you don’t think you can climb and are not excited about tackling, your best bet may be the debt snowball method. Instead of focusing on the interest rate, you focus on paying off the debt with the lowest balance first and then work your way up.
Yes, you won’t save much money this way, but getting out of debt is often an emotional experience, not a logical one. You should choose the method that motivates you the most to get rid of your debt. If getting a small win every now and then is more appealing, the debt snowball method is the right choice for you.
Let’s take a closer look at how these debt repayment methods work as there is more detail behind them than it seems.
Snowballing Your Payments for Momentum
Right now, you may be making minimum payments on your debts, but this won’t allow you to reach debt freedom quickly. If your goal is to become debt-free so that you can live without restrictions, you will want to start making extra payments on your debts. This is precisely how the debt snowball method works. Let’s assume you have 4 debts:
- Credit card
- Credit Card Number 1: $5,000 at 12% interest
- Credit Card Number 2: $1,000 at 15% interest
- Student Loan: $14,000 at 4% interest
- Personal Loan: $10,000 at 7% interest
With the snowball debt method, you will focus on Credit Card Number 2 first. For example, let’s assume the minimum payment is $20. You decide to pay $100 on this card while continuing to make the minimum payments on all your other debts.
So, you will pay a total of $120 on Credit Card Number 2. Once you pay it off, you will move on to Credit Card Number 1. Let’s assume the minimum payment on this card was $60. You will pay $120 that you were paying on Credit Card Number 1, making a total of $180.
After you pay off Credit Card Number 1, you will focus on your personal loan which had a minimum payment of $198. Using the $180 you were using to pay off Credit Card Number 1, you can pay $378 on the personal loan.
Once you pay off the personal loan, it’s time to eliminate your last debt: your student loan. The minimum payment on this was $260, but with $378, you will pay $638 on the student loan.
Through this example, it should be easy to see how you are snowballing your payments together and making a greater impact each time you pay off a debt. If you didn’t use this method and continued to make the minimum payments on all debts, it would take you much longer to pay off your debts. You’re just using the resources you have in a better way. Paying $100 instead of $20 on Credit Card Number 2 isn’t even necessary, you could just pay $20 and snowball it, but it helps get into the mindset of putting extra money towards your debts.
You can use the same principle for the debt snowball method, but the order in which you pay off debts will be different.
Debt Avalanche Method
Another option you have is to use the debt avalanche method, and this method can be used in conjunction with the snowball method or the avalanche method.
As the name suggests, “avalanche” payments simply mean making small payments whenever possible.
Let’s say you find $5 at the gym, or a coworker gives you $10 for the meal you bought for them months ago (and you forgot), or you receive $50 from a relative for your birthday.
In all these instances, you received small amounts of money – this is money you weren’t expecting and hadn’t budgeted for.
Since it is “found money” or “extra money,” it goes straight to your debt. You could have lived without it, so why not put it toward your primary goal of getting out of debt?
You can choose to avalanche payments anytime you have extra money in your budget. For example, suppose you only spent $20 on fuel this week instead of $40 as usual. Send the other $20 to your debt.
Finally, you can use this method if you get paid irregularly. You might be a freelancer or paid on a commission basis, and large additional payments can’t flow through. Try to send smaller payments toward your debt each time you spend less than you thought. Or as a freelancer, set aside 5% each time a client pays you and put it toward your debt.
This method may seem ineffective at first, but the small amounts add up. If you paid an extra $20 every week, that means you could have paid an extra $100 toward your debt! Plus, you’ll have the benefit of feeling that you’re making progress several times throughout the month, every time you make a fresh payment.
How
Should You Choose to Prioritize?
There is no right or wrong way. Like many things in personal finance, it entirely depends on the approach you choose.
The important thing is that you are paying off debts and making progress in this area. Paying off debt brings you closer to your other financial goals, and your money finally becomes yours. You will gain peace of mind from knowing you are no longer in debt to anyone.
Also, it’s not necessary to choose between the two methods. You can try the snowball method, and if you find it doesn’t motivate you, switch to the avalanche method. Your plan doesn’t have to be set in stone. What matters most is that you are focused on paying off your debts.
Don’t Forget to Budget for Payments
Just as you should allocate a budget for savings, you should also allocate a budget for extra debt payments, especially if you are used to paying the minimum.
Review your budget and see if there are any areas you can temporarily pull from. Maybe you can skip dining out for a month and use the $50 you had allocated for that towards the debt. Or perhaps you can cancel cable and start sending $150 towards the debt.
Determine how much you can pay and ensure it is accounted for in your budget. You don’t want to only budget for minimum payments and then use whatever is left at the end of the month towards the debt because you will end up spending that money.
Calculate the extra payments in advance so you are not tempted to spend that money on anything else.
If you are not happy with the idea of cutting back on some things, remember that this is temporary. You can always start a side hustle to earn more money if you prefer to keep the same spending level and send all the extra money you earn towards the debt.
What if you don’t have any extra money, and your debt payments are causing you distress? Contact your creditors and ask them if there is any way to agree on a lower payment to start so that you can gain momentum and perhaps earn the excess
Source: https://www.thebalancemoney.com/how-to-prioritize-your-debt-repayment-4101918
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