Figuring Out Your Financial Style 3: Debt Reduction
Over the last two days I’ve explained why you need to develop your own financial style and what you should think about when building your emergency fund. Today, I’ll guide you through some of the ideas you may want to consider when you plan how to pay off your debt. Developing a debt reduction strategy based on your financial situation, your goals, and your personality is key to your success.
Get A Grip on Your Debt
Maybe I’m the only one like this, but until my wife and decided to focus on paying down our debts, I didn’t know the rates and amounts on all of them. Maybe that’s because I have several student loans in forbearance that I don’t have to deal with very often, but still, you can’t formulate a plan without knowing exactly what kind of situation you’re in. To get a grip on your debt, write it all down, including rates and amounts. I know this is kind of scary–I’m still horrified at all the debt we have–but you need to face your debt if you want to make a plan to get rid of it.
Ask Yourself Some Questions
Which of the debts do you want to get rid of the most? For most of us, this will be the high-interest revolving debts, like credit cards. But there are other debts that you might think are more of a priority. For instance: Do you owe money to any of your family? This type of no-interest loan can be even worse than a credit card. Maybe your aunt is a nasty creditor and complains about the money you owe her to the rest of the family.
The point is that you need to look at every debt you have and then figure out which ones are most important to you to pay off first. Then, you need to see what makes financial sense to you. I’m not going to tell you that a particular order is better, but make sure you realize the implications of paying off your debts in a certain order. For instance: if you follow the “debt snowball” approach (lowest to highest amounts), you’ll pay individual debts off quicker, but you’ll pay more in interest. On the other hand, if you go with the “debt avalanche” method (highest to lowest interest rates), you’ll pay less in interest, but have less psychological momentum. Count the costs and benefits of your plan.
What if the Debt-(insert snow metaphor) Doesn’t Work For Me?
Take a look at how my wife and I applied our own strategy to paying off our debt. We began our quest for financial independence with the following debts (aside from our mortgage):
1. Credit Card: $4900 14.99%
2. Student Loan 1: $5500 2.25%
3. Student Loan 2: $17,000 4.75% Forbearance
4. Student Loan 3: $5700 4.75% Forbearance
5. Student Loan 4: $5000 6.8% Forbearance
6. Student Loan 5: $7300 6.8% Forbearance
7. Second Mortgage: $28,000 9.2%
According to the debt snowball method, we would pay them in the following order: 1, 5, 2, 4, 6, 3, 7. However, where do loans in forbearance fit into the snowball? Since we’re not paying on them right now, if we pay one off, it doesn’t build our snowball at all. It doesn’t work for our situation.
According to the debt avalanche method (highest to lowest interest rate), we would pay our debts in the following order: 1, 7, 5, 6, 4, 3, 2. This would save us the most money, but we would also lose some of the momentum that you can gain from paying debts off quickly.
What DOES Work For Us
My wife and I are tackling the credit card debt first. I can’t stand credit card companies and I’m going to do everything in my power to make sure I give them as little of my money as possible. After that, we’re going to pay off Student Loan 1. Here’s why: It has a pretty low balance and if we pay it off quickly, we’ll gain some momentum, AND be able to snowball the money into the next debt in our crosshairs: the Second Mortgage. This is a huge debt and it’s at a relatively high interest rate. We’re going to leave the student loans in forbearce (since they’re at low interest rates) and take care of this debt next.
We’ll have a huge momentum and snowball boost after we get it paid off and we’ll tackle the student loans one at a time, taking them out of forbearance and paying them down as quickly as possible. We’ll do it in the following order to avoid as much interest as possible while building momentum towards our final goal: SL 4, SL 5, SL3, and SL 2.
As you can see, there is no “right” or “wrong” way to pay down your debt. There are different approaches, each with their pros and cons, but if you want to succeed build a plan based on your own situation. Tomorrow we’ll have the final installment in the Figuring Out Your Financial Style Series. We’ll look at Retirement Planning and help you figure out what’s best for you.
Here are the rest of the posts in the “Figuring Out Your Financial Style Series”
Thanks to garretc for the photo.
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