Step-by-Step Approach to Paying Down Debt
The Best Way To Pay Off Debt
If you have a few different types of debt, it can be confusing to know how to tackle each debt and in what order. I'll go through some of the different types of debt and introduce you to a step-by-step approach to allocating your money.
Some Unhelpful Advice - You Shouldn't Take On Lots Of Debt (but if you do...)
You've probably heard this already, but you shouldn't take on high interest debt if you can't pay it off immediately. You should only purchase something on a credit card if you can pay it off in full when the monthly payment is due. Credit card debt is what we call bad debt.
Some kinds of debt are practically unavoidable for most people, such as a mortgage or a car loan. In contrast to bad debt like credit cards, these are generally considered good debt.
If you're reading this article, however, you probably have some credit card debt and you want to know the best way to pay it down. Let's start by looking at these two types of debt in more detail.
Good Debt and Bad Debt
Debts are often categorized as good and bad debt.
Good debt is:
- Debt that will help you accumulate wealth; or
- Low-interest debt
Debts can often be in both categories. Think of a student loan. Furthering your education is one of the best ways to boost your long-term earnings by getting a better job. Student loans also have lower interest rates than many other kinds of debt.
Another example is a home mortgage. Real estate appreciates in value over the long term, and a mortgage is much lower interest than, say, credit card debt.
The most common kind of bad debt is credit card debt. It's much higher interest than most other kinds of debt, including car loans, personal loans, or a mortgage.
About the only kind of debt that's worse is a payday loan. These have outrageously high interest rates for the convenience. Never take a payday loan.
Pay the highest interest debt first.
The Simple Step-By-Step Approach
Pay the highest interest debt first.
That's the biggest takeaway. If you remember this, you'll be on your way to getting under control.
Simple Interest Versus Compound Interest
Whether it's a credit card, a mortgage, or a car loan, it'll have a specified interest rate. But it's important to understand if it's simple or compound. Here's the difference.
- Simple interest applies just to what you borrowed. Interest doesn't accrue over time.
- Compound interest does accrue over time. That means you're paying interest on other interest.
Compound interest adds up much more quickly, both for investments and for debts.
Step 1 - Write Down Your Debts and the Interest Rates
You need to know what your different interest rates are.
- Your mortgage and your car loan should be well under 10% (hopefully quite a bit lower than that).
- By contrast, credit cards usually start at 10% and go up from there. If you have rewards cards - cards that earn airline miles, hotel points, or cash back - then the interest rates will be even higher.
Step 2 - Pay Minimums On All Debts Except For The Highest
You read that right. This is always going to be the best way to pay off your debt and minimize the interest. For a car loan or a mortgage, it's a set monthly installment (because they're simple interest loans). For credit cards, it'll change as the balance changes.
Step 3 - Pay As Much As You Can On The Debt With The Highest Interest Rate
The key to paying off your debt in the most effective way possible is save up as much of your monthly budget as you can and use it to pay off the highest interest debt. Here's why it works.
Any debts that are simple interest aren't piling up. A car loan charges interest, but it has a much smaller effect because you're only paying interest on the amount you borrowed.
Credit cards will increase faster, especially because they charge compound interest, but you want to attack the one that's growing the fastest.
Paying as much as you can on the worst debt is mathematically much better than paying a little more than the minimums on all your debts. And this is especially true when you consider bad debt versus good debt. If you have a mortgage and a credit card with a balance, you shouldn't pay extra towards the mortgage until you've paid off your credit card.
How Compound Interest Grows
Example Using Realistic Numbers
Let's use an example. Sally has a car loan at 5.99% and three credit cards: an American Express at 15.99%, a Visa at 18.49%, and a MasterCard at 22.99%.
- She knows how much her car loan will be: it was set out on the paperwork when she bought it. Let's say she pays $259 a month for her car loan. She should keep paying that amount and no more so long as she has any credit card balances.
- Because Sally has written down the interest rates, she knows that the highest is the MasterCard at 22.99%. Every month, she should pay the minimum on the other two cards, and no more.
- Sally should take as much as she can and use that to pay extra towards the highest interest credit card - in our example, the MasterCard.
Once she's in this routine, Sally needs to keep doing this until the MasterCard is completely paid off. Even when the balance drops below the amounts she owes on her American Express and her Visa, she should keep paying as much as she can until it's at zero.
Once she's paid off the MasterCard, Sally can use the same strategy to pay down the next highest interest rate debt - in her case, the Visa at 18.49%.
There are some other approaches. A very popular method is paying down the smallest debt first. This is called the snowball method.
It's popular because a lot of people find it much more motivating. Paying the smallest debt off first means you start seeing tangible results - a reduction in the number of different debts - much sooner. So our steps above would change like this:
- Step 2 - Pay Minimums On All Debts Except For The Smallest
- Step 3 - Pay As Much As You Can On The Smallest Debt
Some people swear by it, but the math is undeniable: if you can stick to the approach shown above, it will pay off your debt more quickly than the snowball method.
Pick An Approach And Start Today
I've said throughout this article that the approach listed here - pay the highest interest debt first, until it's zero - is the best. That's because it is guaranteed to get your debts paid down the fastest.
But some people find it too demoralizing to be making high payments and still have multiple debts open. If you know that this is how you work, then you should read up on the snowball method.
The crucial lesson, however, is you have to pick a method and stick with it. If you know the snowball method will work better for you because it's more motivating, then don't get too fixated on the differences in the numbers.
Make a plan, and attack your debt starting now!
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.