Get Rid of Your Debt!
This post is part of the financial basics series
When you have multiple credit cards, car payments, student loans, and other consumer debt it’s easy to begin to feel overwhelmed by the payments.
If you want to take control of your debt, it is important that you have a method and a plan to pay your debts off. A plan will give you control and put you one step closer to financial freedom.
So how does it work?
The first thing you will need to do is make a list of all your debts, including the balance and the minimum payment due each month. Next you will need to figure out your budget and determine the maximum amount of money you can pay towards your debt each month. Ideally you can pay more than the total minimum payments, but it may be that the most you can pay is the minimum amount due. This is fine. If the total amount you can pay is less than the minimum payment you need to go back and rebudget, and figure out where you can cut costs elsewhere so you can make your payments.
Now that you have a budget, you will need to decide which debt to pay off first. There are multiple ways to choose which order you should pay your debts off, but there are three main schools of thought on which debt payoff order is best, each with it’s own pros and cons which you should consider.
1. Payoff the lowest balance debts first (the debt snowball)
This is the method advocated by Dave Ramsey, and is the method my wife and I are using to payoff our debts. Using this method you will put any extra money towards the debt with the lowest balance, paying extra on it every month until it is paid off. When that one is knocked out you will put all of the money you were paying on the first debt and add it to the minimum payment of the next lowest balance debt, paying extra on it until it’s paid off. You will keep doing this until you have paid off the last debt. By the time you get to the debt with the largest balance you should be able to put a massive amount of money towards it every month (hence the name debt snowball), since the rest of your debt will be gone. While it may not actually be the quickest method to paying off your debt, it will feel like things are in motion since you every few months you can potentially get rid of another debt payment, which means one less bill in the mailbox.
The downside is that, mathematically, it is the least efficient method if your highest balance debts are also the ones with the highest interest rates, and over time you will end up paying the most amount of interest. My wife and I actually faced this dilemma, since our credit cards have both higher interest rates and higher balances compared to our car loan and student loans. Still, the excitement for us of paying off our car is worth the higher costs.
2. Payoff the highest interest rate debts first
With this method, endorsed by Suze Orman, you will order your debts from the highest interest rate to the lowest interest rate, and begin to pay them off in that order. Again, once a debt is paid off you will put that money towards paying down the next debt. As I said before, if you are looking for the method to pay the least amount of interest over time, and the method to pay off all debt in the absolute quickest fashion, this is the one to use.
The only downside to this method is a psychological one. If your highest interest rate debts also have high balances, it might take a long time to pay them off. It may begin to feel like you’re not getting anywhere with your goals, and you may find yourself in a rut. And if this leads to a breakdown in discipline, you might go off on a spending spree and quit altogether. And that, of course, would not be good.
3. Payoff debts according to their ‘DOLP’ number.
DOLP (Dead On Last Payment) is a trademarked term used by David Bach, author of The Automatic Millionaire. This system actually works out to be a hybrid of the previous two methods. To use this method you will need to find the DOLP number for each debt, calculated as the total balance divided by the minimum monthly payment due. Once you have all of the DOLP numbers calculated, you will order them from lowest number to the highest. The lowest DOLP debt will be paid of first, and the highest last. If you have no extra money to pay down your debt every month you are actually using this method by default, since you will pay off whatever debt is receiving the highest % of its balance first.
Let’s look a little deeper into the DOLP method. There are two ways a debt could have a low DOLP number. The first is if the minimum payment due is large relative to its balance. For example, consider two credit cards with the same balance, but with different interest rates. The credit card with the higher interest rate will have a higher minimum payment, and thus a lower DOLP number, and should be paid off first. The other factor leading to a high DOLP number is a relatively low balance. An auto loan payment for instance, is a fixed amount every month. As the balance gets lower, the DOLP number goes down, meaning you will pay it off sooner. Getting rid of low balance debts means more money freed up to pay down other debts, and one less bill in the mail every month to worry about.
In short, using the DOLP method prioritizes higher interest rate debts and lower balance debts. Of course using this method doesn’t guarantee that you will pay off the highest interest rate debts first. You can still end up paying more interest over time than simply paying off debts in order of the highest interest rates.
Attack your debt
Once you have decided what order you will pay your debt off, the next step is to start doing it. Being consistent every month is the hardest part, especially if you figure out that it is going to take years to pay everything off (like I did). You may think to yourself “What’s the point?” I know this feeling well, but if you don’t do it now, when? Unfortunately your debt is not going to magically disappear. The only way to overcome it is to attack it with every bit of money and effort that you can. Keep picturing how great it will be to not have anymore debt. And think about the money you will have to save every month once that debt is out of the way.
It won’t be an easy road, especially if you have a lot of debt. But stick with it and you will be debt free before you know it.
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