Nickeled and Dimed

After outlining the four keys to my plan for financial freedom, I received a few requests to go into more detail on each.  So for the next five days I will be making all posts regarding those four principals.  Today’s will cover the different strategies for paying off your debt.

The average American pays over $1,000 a year in interest fees and carries a balance of around $9,000 on their credit cards.  It’s easy to see that debt, especially credit card debt, is a major bump on your road to wealth.  But simply deciding to pay it off is not enough.  You need to have a plan.  Here are the two main strategies among personal finance experts for paying off debt.

Highest Interest Rate First

The most widely preached strategy for paying off debt is the approach of paying off the card with the highest interest rate first, then moving on to the one with the next highest rate, etc.  Economically, this approach makes a lot of sense.  By paying off the highest rates first, you minimize the amount of interest you pay in the long-run.

Here’s how it works:

• Order all the debts you want to pay off from highest interest rate to lowest interest rate.
• Determine how much money you will put towards your debt each month.
• Make the minimum payments to all debts except the one with the highest rate.
• Apply all remaining money to debt with highest interest rate until it is fully paid off.
• Use all money you were putting toward debt that is now paid off to the debt with the next highest interest rate.

Let’s look at an example:

•  You have three debts with equal $500 balances, one with a 20 percent rate, one with a 15 percent rate and one with a 10 percent rate.  The minimum payment for each debt is $50.
• You will put $200 towards this debt each month.
• Make the minimum $50 payments on the 10 and 15 percent interest debts.  Use the entire remaining $100 to go towards the debt with the 20 percent interest rate until it is paid off.
• After the 20 percent rate debt is paid off, continue making the $50 minimum payment on the 10 percent rate debt.  Use the $50 payment you had been making, plus the $100 payment you were making on the old debt, to go towards the 15 percent rate debt until it is fully paid off.
• After the 15 percent rate debt is paid off, use entire $200 to pay off the remainder of the 10 percent rate debt.

Advantages of this plan: Organized plan to pay off debt that will allow you to pay the least amount of interest possible.

Disadvantages of this plan: If highest interest rate debts also have the highest balances, it can be psychologically draining to see little progress each month.

The Debt Snowball Method

A second method, which was made famous by Dave Ramsey, is called “the debt snowball method”.  The idea with this strategy is to pay your debts off from lowest balance to highest balance.  The philosophy behind this is that by paying off the smaller debts first, and seeing success, it will keep you motivated to keep going.

Here’s how it works:

• Organize debts from lowest balance to highest balance.
• Determine how much money you will put towards debt each month.
• Make minimum payments on all debts except one with the lowest balance.
• Use all remaining money and put it towards debt with lowest balance.
• After lowest debt is paid off, continue strategy with next lowest balance.

And an example:

• You have three debts, one has a $500 balance, one has a $250 balance and the third has a $100 balance.  The minimum payment for each is $25.
• You have $100 to put towards debt each month.
• Pay the minimum $25 to the $500 and $250 debts and use remaining $50 to go towards $100 debt.
• When $100 debt is paid off, continue making $25 minimum payment to $500 debt and use remaining $75 to go towards $250 debt.
• Continue until all three are paid off.

Advantages of this plan: Psychologically motivating to see progress as entire balances of debt are paid off.

Disadvantages of this plan: Could pay more in interest fees if higher balances are also highest interest rates.

No matter which plan you choose, or if you create your own plan, the important thing is finding a strategy that works for you.  I have personally found that the debt snowball method is best for me as I like the feeling I get when one of my debts are completely gone.  For others the idea of paying the least amount of interest will be what motivates them.  What matters is that you follow through with your plan and get your debt paid off.

Tomorrow Centsability to Wealth will discuss how to start an emergency fund.  Please continue sending any advice, questions and story tips to centsabilitytowealth@gmail.com