When it comes to paying off debt, there are generally a variety of ways in which you can do so. The one that, unfortunately, too many people opt for, is to simply pay the minimum payments that the lender asks for. If you’re reading this blog, you’ve probably already realized that this is a terrible financial decision. People only choose this option when they’re on auto-pilot, and live in denial of their current financial decision. Many times I’ve had a $10 minimum payment on a $1,000 balance. Paying just $10 would be ridiculous, and would cost you dearly over the next 20 years.
So, assuming you already realize that you want to pay more than the minimum on your debts in order to pay them off, you still have a long way to go. Your approach, in my opinion, should consider both mathematical and psychological aspects of the debt-paying process. Let’s look a little more at the steps that should be taken to pay off your debt in a manner that reaches your financial goals, but also improves your well-being psychologically.
Step 1: Create an Emergency Fund
Similar to what Dave Ramsey proposes, I think that $1,000 is a good emergency fund to start with. Your eventual goal here will be about six months of expenses (the number of months can vary depending on the stability of your income source). The small $1,000 fund allows you to keep on track even when you have small emergencies. You don’t want your progress to being debt free to be halted by a small emergency. It’s recommended that you keep the emergency fund in cash. The reason for keeping it in cash, rather than stocks or bonds, is for liquidity. We don’t want to have to sell an investment to get cash because we could be forced to sell when the investments are down. As a general rule of thumb, you shouldn’t investment any money you’re going to need in the next 5 years. Take this from someone who learned the hard way.
Step 2: Avoid New Debt
If you’re digging yourself out of debt, it makes sense to not throw debt back into the hole, right? To ensure that you’re making the most progress toward your goal of being debt free, you should not take on additional debt when you’re in debt pay-down mode. You’ll need to assess how you can make this happen. If you’re in school and paying for it with student loans you should pay for future school expenses instead of paying off your previous student loan debt. If you’re bad with credit cards, you should lock them away where you can’t access them. Oh, and don’t forget to remove the cards from your Amazon account. If you can truly manage your credit card expenses and pay the balance every month, I’m not going to tell you not to use them. I think the credit cards provide many benefits, particularly for extended warranties, protection from shady merchants, and the ability to easily track expenses through a website such as Mint.com.
Step 3: Paying Your Debts
Now, this is the part where the debate amongst financial planners and gurus begins. Dave Ramsey is a proponent of the Debt Snowball. Under this approach, you list your debts, excluding the house, in order of dollar balance. The debt with the smallest balance should be your number one priority. Don’t worry about interest rates unless two debts have similar balances. If that’s the case, then list the higher interest rate debt first. This ignores the interest rate that your debt is costing you. When you’re paying off the debt with the smallest balance, pay just the minimum payment on the rest. The reason for this method is that, as you pay off one of your debts, you will continue to be motivated. The math involved in personal finance is easy. Controlling your emotions is a completely different story.
A differing method of determining the order to pay your debts is one that uses strictly math, and ignores the emotional and psychological effects. Flexo of Consumerism Commentary coined this the Debt Avalanche. Basically, you pay off your debt with the highest interest rate first. Nobody will argue that this math doesn’t make sense. You’re going to pay less on your debt and you’re going to pay it faster. Just list your debts by interest rate, pay minimums on all your debts, and any extra cash goes to the debt with the highest rate.
I’m going to say that neither of these is the correct approach for all people. You need some type of framework to use in order to make this decision for yourself. In some instances, it will make more sense to use a Debt Avalanche approach. In others, the Debt Snowball may be your best shot. So to determine what the best approach for you is going to be, first head over to this calculator. Select the number of debts you have and input the information for each. I want you to basically run this calculation twice. Once in “Interest Order”, and once in “Balance Order”.
For me personally, I ran my personal student loan of $9,800 and my parent student loan of $33,000. These loans have interest rates of 5.8% and 6.8% respectively. If I were to pay off these debts using the debt snowball, it would take me 49 months and I’d pay $5,943 in interest. If I paid the loans, with the highest interest rate first, I’d pay $5,695 in interest. Basically, if I choose to do the Debt Snowball, it will cost me $248 in interest, but my repayment time will be the same. In this instance, I think it’s more than fair to consider the emotional implications of your repayment order. I know that paying my $10k personal student loan will provide me with much more general happiness and will lighten the psychological burden that this student debt has placed on me.
However, and this is the key point, I can only consider these psychological factors because the difference in total interest paid is not greatly affected by the order in which I pay the debt. This is because the interest rates on the two debts are not very different. If, however, you are contemplating paying a student loan and paying a credit card, you should without a doubt pay the credit card first. Let’s run through a quick scenario here to show the math. Let’s assume I had my $9,800 student loan, but I also had $15,000 in credit card debt. Due to having such a large balance and deteriorating credit score, we’re assuming the credit card company bumped the interest rate up to 23%. Paying $500 toward this debt each month, it would take 80 months to pay off the debt and would result in $15,048 of interest. And that’s if I paid it based on interest rate. Now, what if I decided to pay based on balance, as proposed by Dave Ramsey’s Debt Snowball? I would pay $31,796 in interest and it would take me 114 months. That means, by using the Debt Snowball approach instead of the Debt Avalanche approach, I’d pay an additional $16,748 in interest and it would take me almost three additional years to pay it off.
I think it’s fairly clear here, that determining the order to pay off your debt takes more than just a simple “rule”. If the difference between the two payoff schedules is large, then go with the Debt Avalanche. If the difference is small, and you believe you’ll receive the psychological benefits associate with it, then by all means use the Debt Snowball. If, however, the differences are small, but you don’t think you’ll benefit at all psychologically from kicking out the small debts, then you might as well also follow the Debt Avalanche approach and pay off your interests in the order of highest-interest to lowest.