This is part of a weekly series on personal finance and wealth building. If you care to read them all, please click on the ‘Building Wealth’ category on the right.
If you’ve followed along for the last several weeks, you’ve gotten to the point that you are ready to develop and implement a debt repayment strategy. You’ve seen the five basic steps to maximizing wealth, you’ve built your balance sheet, income statement, and your budget. Now it’s time to get you out of debt.
How you got into this mess is largely irrelevant. I’m not judging, and you shouldn’t beat yourself up. I know I made a lot of poor choices when I was younger when it came to money, and I paid for it. The good news for you is that, like with almost anything, if you put your mind to it, stick to a plan, and work hard, you can get out of overwhelming debt faster than you think.
In a future post, I may cover some things you might find in your budget that you can eliminate. While frugality might be a necessity in some cases, I prefer to focus on the plan and the strategy, not on posting ‘5 ways to save money at the grocery store’ articles. For now, I’m assuming you’ve put your budget together, and on your own you figured out where your money is, where it goes, and how much you’ve got.
There are probably hundreds of resources in bookstores and on the web that will tell you (or sell you) the secret to getting out of debt. What you read here might not agree with what other say. I’ve read pay off the highest balance first, the lowest balance first, put the same amount extra towards each debt, and a host of other strategies. The one I suggest is the simplest, and the most effective, assuming your goal is to increase your net worth as quickly as possible. I’m also assuming you are not in such dire straights that you are making the choice between paying your bills and eating. If you are, you may need more personal help than I can provide, although if you leave me a comment (I’ll never publish an email or name unless you give me permission) I’ll do my best to point you in the right direction.
The first step to paying off your debt is to compile a list of all your debt. On that list the creditor, the current balance owed, the current interest rate, and the minimum payment. I suggest using a spreadsheet, because working with the information is easy. Once you’ve done that, sort the list by interest rate, highest to lowest. Include your car loans, student loans, money you owe your grandma. Do not include your mortgage, or debt on investment real estate, unless it is a line of credit or other home equity loan.
An important note: any debt on an appreciating asset (typically just your mortgage) should not be included in this calculation. Paying off your mortgage early is another subject, and is often counter productive to building wealth. Even in the recent housing market where we’ve seen values decline, I would not include your mortgage in your debt repayment plan. There are some special circumstances where it might be, but those will typically fall into the ‘dire straights’ category, where you may be considering foreclosure, short sale, or bankruptcy. Those subjects are outside the scope of our discussion.
Next, stop using your credit cards and do not buy anything on credit until you are where you want to be. The only time you can ignore this step is if you have a very large unbudgeted legitimate emergency. Not remembering your mom’s birthday is not an emergency. Having your transmission break is. Breaking your glasses is. The kind of stuff you can’t ignore, can’t avoid, couldn’t predict, and need to deal with now. At that point, I’m OK if you use a credit card. As I’ve discussed before, I don’t recommend a large ’emergency fund’, I think you are better off not paying interest to keep that fund.
If your TV breaks maybe you should listen to the radio for a while.
The next step is remarkably simple: take every bit of the cash flow that your budget allows, and send it to the creditor with the highest interest rate. Continue paying the rest of your creditors the minimum payment. Repeat every month until that debt is gone. If it’s a bank credit card, keep the card and keep the card open. If it’s a department store card or gas card or some other line of credit that is specific to a brand or business, close the card. If it’s a car loan, congratulations, this is one of those milestone steps you’ll look back on fondly.
The month after you pay that card off, take all the money you were sending them, and send it to the debt with the highest interest rate. Again, keep going until you pay that off, then move on to the next debt.
Two things happen as you pay debt off this way. Your net worth increases the most in the shortest amount of time by eliminating interest expense along with the liability, and with every debt eliminated, you put more against the remaining debt, and pay each one off a little quicker. As you eliminate each debt, you add that minimum payment to the money you have to apply to the next one. I think Dave Ramsey calls this a debt ‘snowball’. Some think this is why you should pay off the smallest balance first to be able to move the minimum payment to the next debt more quickly; that’s incorrect, as you need to evaluate your debt as a whole, and if you do that you end up paying more interest in order to pay off the smaller card, which eliminates the debt more slowly and slows down the growth of your wealth.
Simple enough, right? So you know what to do, start doing it.
Next week, we’ll either go over some ways you can increase the money available to pay off your debt (one of those living frugally posts), or we’ll talk about goal setting. Or something else.
As always, questions and comments are encouraged!