If you’re like most Americans, you probably have some amount of consumer debt. I define consumer debt generally as credit card debt, but it can also mean debt for purchasing cars or boats. In general, I do not put student loan debt or home mortgages in the same bucket when I advocate paying off consumer debt.
Sometimes people refer to different types of debt as “good debt” or “bad debt.” But I’ll be completely honest: To me, there is no such thing as good debt. Sometimes you’ll have necessary debt, such as taking out a mortgage to purchase a home. In general, my counsel is no debt should ever be considered “good” to have. The best approach is to have as little debt as possible, preferably zero debt.
Most people approach paying off debt in a haphazard way. Usually, this entails paying a little extra on all of their monthly credit card bills. While well-intended, this is the wrong approach. Sprinkling extra principal payments around does slowly whittle down debt balances but the operative word here is slowly. In fact, the process moves as fast as molasses and typically leads to surrendering because you feel you’re getting nowhere.
Debt Snowball Technique
The better approach is to use the debt snowball technique. Dave Ramsey recommends this approach, and I have been recommending this method for over twenty years – long before my acquaintance with Ramsey’s work. Basically, when snowballing your debt payoff, consider either the highest interest rate first method or the smallest balance first method.
The first step for either method is to make a list of all your debts. You can simply make your list on paper or, if you prefer, create a spreadsheet. Be sure to list ALL your debts, including your mortgage, car payments, credit cards, medical debts, and student loan debts. You want to include the following information for each debt on your list:
- Current outstanding balance
- Current minimum payment
- Current amount each month you are paying over and above the minimum (if any)
- Interest rate on the debt
Once you complete your list, put the debts in order depending on the method you prefer.
Highest Interest Rate Method. All your debts, except for your mortgage, should be listed from highest interest rate to lowest interest rate. The debt with the highest interest rate should be the one to focus on first. Your mortgage will always go last.
Smallest Balance Method. All your debts, except for your mortgage, should be listed from smallest balance to largest. Just like with the previous method, your mortgage goes last, regardless of where it might place on the list. (Dave Ramsey recommends this approach.)
Hybrid Method. My approach is a combination of these two ideas. I start by organizing by highest interest rate first. Then I will shift my sequence of debts to move smaller balances to the first positions in the list. If some balances amounts are close, I will order the higher interest rate ahead of the others.
The next step is to tally up all the extra (if any) you pay on your various debts each month. For instance, maybe you round up your minimum payment on five different debts for a total of $50 per month.
From this point, apply ALL the extra (in my example, $50) you have been paying on your various debts to the FIRST debt on your list. Meanwhile, you pay only minimum required payments on all the rest, including your mortgage. (Resist the temptation to continue “rounding up” or otherwise adding extra principal payments on your mortgage until the rest of your debts are paid off!)
With this sequence set up, study your budget to find areas in which you can cut expenses to free up some additional monthly funds for debt payoff. Whatever you find, add it to the above extra payments each month to the FIRST debt on the list.
Continue this process until Debt #1 is paid in full. As soon as it is paid off, you will now apply every single dollar you were paying on that debt to Debt #2. You’ve been making minimum payments on Debt #2 so simply add on the entire Debt #1 amount to the minimum.
Again, continue this plan until Debt #2 is paid in full. At that point, roll all the funds you were paying on Debt #2 onto Debt #3. Continue this plan until all your debts are paid off.
This process can take years to complete (don’t get discouraged!) so it’s important to periodically review your budget and find more funds you can divert to accelerate the payoff.
Pros and Cons of the Two Methods
If you choose to pay your debts off by prioritizing by the highest interest rate, by the end of the project you will have saved the most in interest payments. However, you may also be putting a larger debt in front of a smaller debt, and consequently it may take several months to years to pay off a debt. You may feel you’re not making enough progress and opt out with the attitude of “Screw it, I’ll just quit.”
On the other hand, paying the debts off by starting with the smallest balance has the advantage of some quick wins. Paying off smaller balances might be a quicker process, and you’ll feel like a super hero when you pay off the first one. You will likely pay more in total interest charges this way, but the psychological edge you get from knocking some debts out early will often be worth it. Momentum is a powerful thing.
My hybrid strategy addresses these pros and cons by starting with smaller balances. When the balances are relatively similar, starting with the highest interest rate will help you save as much as you can on interest over the life of the project.
Stop the Bleeding
Just remember this: It is imperative to “stop the bleeding.” You cannot continue to use credit to buy things that you cannot pay for in full when the bill comes. Assuming you are careful and diligent and have a balance-free credit card, use it for things you like to pay for with a card. But ALWAYS pay it off in full each month.
If an emergency or unexpected expense occurs, and you cannot pay the card in full, don’t despair. Instead, make THAT credit card number one on your list and get it paid in full in as short a time as possible. Then resume your plan. No need to freak out and quit. Life happens sometimes. If these “emergencies” continue to happen, however, step back and evaluate the underlying problem. Find expenses that need cutting to prevent further backsliding in the future.
Mortgage Goes Last
Only when all (and I do mean ALL) of your other debts are paid should you turn your attention to your mortgage. Some people find this extraordinarily difficult. The thought of paying a mortgage for thirty years is never pleasant. The key is to trust the system. Paying your minimum required mortgage payment while you accelerate the payoff of the rest of your debts is imperative.
When you are able to focus your monetary attention to accelerating your mortgage payments, imagine how large your snowball has become! Each time you pay off a debt, the amount of “extra” you can apply to the debt next in line increases. By the time you get to your mortgage, you may realize thousands of dollars extra each month. Don’t give up!
This is all doable. But it does require a change of mindset. You must be willing to forgo luxuries along the way to free up cash flow to help accelerate the debt payoff. Stories of people focused on their goal abound, proving it possible to pay off debt and do so in a relatively short period of time.
It can be done! Focus. And trust the system.
Have you had success with getting your debts paid off? Share your story below.
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