And which is the correct method for you, depending on your personality.
So you have debt. Welcome to the club of 8 in every 10 Americans who hold some sort of debt. Whether this debt is good or bad, necessary or not, is a debate we can leave for another day, or maybe never — because it is academic at this point! The fact is that you already hold debt. It is how you deal with it from now on, which will determine your financial future.
Let us not complicate things — there is only one thing that you need to do with debt, and that is to pay it down. There are some questions that remain — which debts are to be paid off quickly, in what order and how. This isn’t rocket science, simply a matter of making sound, practical decisions about what sort of life you want to lead.
I promised you a step-by-step guide, so here it is:
Step 1 — Make a list of ALL your debts
The very first step towards solving anything in the world is an acknowledgment of its existence. You need to acknowledge every single debt that you owe — from an overdue credit card to money loaned by your loving family. The only debt that should not make its way to this table is a credit card balance which is within its due date, i.e. the current monthly balance.
Step 2 — Get some more information on your debts
It is horrifyingly common for people to not know even basic facts about their liabilities, like interest rates, tenure, fees for late payment, etc. I am pretty certain that if people knew the APRs on their credit cards, they would think twice before carrying a balance. In any case, now is as good a time as any to find out some crucial details which would affect how you tackle the debts:
- The total amount of debt pending — you can get this by calling up your debt provider and asking them to send across your latest statement
- The interest rate being charged — this can be easily found out if you have the documents sanctioning the loan, or in the case of credit cards, the information brochure that came along with it. If these aren’t handy, you can contact the company and they will let you know.
- Minimum payment to be made per month — this would most likely be on your latest statement, in the case of credit cards. For other loans, this would be on your original documentation. As always, you can call them up and ask them too.
- Payment you are currently making — your bank statement can be checked for finding out exactly how much money is being paid to which debt.
- Surplus payment being made — this is simply the difference between the payment you are currently making, and the minimum payment to be made per month. Please note that this figure can also be negative, which means that you are paying less than what is the minimum requirement, and are effectively defaulting on that loan.
Once you are done with all these, you should have a Personal Table of Debt that looks somewhat like this:
Step 3 — Ensure that you have a surplus in the last column
It is quite possible that, unlike in the example given above, which has a surplus payment of $350 a month, you could have $0 or even negative values there. This is the definition of a rut — a numerical representation of someone ‘drowning’ in debt. As long as this value is not positive, you will never be able to pay off your debts. Sorry to be harsh, but trying to pay off your debts in this situation is mathematically impossible — they will grow at a rate that is more than what you are repaying. I cannot stress this enough — there needs to be a surplus.
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But what can you do if it isn’t? There are a few methods of doing that —
- The first one, and the most obvious one, is to trim your budget and find a few extra dollars here and there that can be redirected towards your debt repayment. It can also be a temporary measure since once a debt gets knocked off your table, you will automatically find extra room in your budget.
- The second one is a more desirable and sustainable method, but also difficult to implement. That is to find a new source of income, even if it is just a hundred dollars a month. At this point, anything and everything will help.
- The third one, and the least desirable, is also very counter-intuitive. And that is to get some more debt! Hear me out. I don’t mean another credit card. But there are lower interest rate debts that you can take out to get out of high-interest rate debts, like getting a home equity line of credit, a balance transfer to a credit card with near-zero interest rates for a limited time period, or if everything else fails, a loan from friends or family.
- If all these options are not workable for you, (or even if they are, there is no harm in trying), you can contact your debt providers and try to negotiate lower interest rates/lower minimum payments. After all, it is in their interest to keep you paying off the debt. A bankruptcy hurts them as much as it hurts you.
Step 4 — Prioritise your debts
Now that you have figured out a surplus, it is time to decide which debt you should apply it to.
It is here that financial gurus differ on the method to be followed. If you aren’t ‘in’ with the terminologies, no need to fret. Broadly there are two — the debt avalanche, which prioritizes the worst loans (the ones with the highest interest rates), and the debt snowball, which prioritizes the smallest loans.
If you are someone who is more logical, is okay with waiting a bit for your first ‘success’, and can be motivated enough by just seeing the total debt owed reduce month after month, the debt avalanche is ideal for you. Purely mathematically, this method is far superior to the snowball and will save you money and time. But its only disadvantage is that it may take some time before you get the rush of crossing off a debt from your table.
On the other hand, if you are someone who is more emotional when it comes to money decisions, and who is more motivated by small wins along the way, the snowball might be good for you.
Remember, it is not a decision set in stone — you can always change your mind if you feel the current method isn’t working for you.
Now that you have decided which method is right for you, sort your table — by the interest rate (descending order) if you decide to go with the Avalanche, or by the amount of debt (ascending order) if you go with the Snowball.
Step 5 — Reduce the payments made to minimum
Except for the debt at the top of your table, reduce (or increase) the monthly payment so that it matches the minimum payment on that loan. As they say, not a penny more, not a penny less.
Step 6 — Increase the payment to your Top Debt
Now, you are left with an amount equal to the minimum payment on your Top Debt plus your surplus. This entire payment will be redirected to your top loan, making your Table of Debt look something like this:
Step 7 — Track your debt monthly
As they say, the only constant is change. Your debts will continue to change, affected by your payments as well as the interest adding up. That is why it is important to track these figures monthly.
The Table above will change as below:
Notice that your total debt only reduced by $734 despite making payments of $950. That is what happens when the magic of compound interest works against you.
But there is a silver lining — soon enough you will have knocked off the first debt completely.
Step 8 — Rinse and repeat
The rest is simply a matter of consistency. Once you keep paying as per the plan, your first debt will get knocked off soon. At that point, you will have a sizeable surplus, since you would have been freed up from making even minimum payments for that particular debt. Redirect the entire surplus towards the next debt in line, and watch as the numbers accelerate towards zero!
Note that not all debts should be paid off rapidly. Since you can expect an average return of about 8–9% from your investments, anything above that definitely needs to be paid off. Anything below 5% can be delayed. In the mid-range of 5–8%, you should take a call depending on your own risk appetite (the higher the risk you are willing to take, the higher will be your return from investments) and the time horizon for investments (the longer the time available with you before you retire, the higher will be your return).
Bonus Step 10 — Bump up your surplus
There will be times when you have a little cash lying around here and there. Maybe a bonus, or an unexpected birthday gift. Whenever you do, you can pledge that towards your Top Debt of the moment. It does not have to be sizeable or recurring, every little bit will take you closer to never having a Table of Debt again!
I have put together a handy little Personal Finance Crash Course e-book, covering everything from budgeting and investing, to retirement and goal planning. Click here to check it out, and thank you!