Understanding how we think, what our goals and objectives are, what we fear and what motivates us is vital to our financial success. Financial solutions only work when they address your unique situation. When paying off consumer debt, it is necessary to recognize who you are and how you think.
Where to Start
Different theories are easy to find, but which one will really help you most effectively pay off your debts? Which will help you stay motivated to complete a process that may take years depending on your income, expenses and debt load? Regardless of which debt payment strategy you use, here are some steps to get you started thinking about how to pay off your debt. (For more, see: Budgeting Basics.)
- Operate your finances with a monthly spending plan. This will maximize the efficiency of each dollar of income you have available. No dollar is wasted or lost to frivolous spending.
- Make a complete list of your non-mortgage debts. List every credit card, car loan, personal loan, payday loan and student loan you have. It may be painful to see, but ignoring it won’t make it go away and doing so will make it much more painful in the long run.
- Make sure you’re making the minimum payment on each debt and that they are included in your spending plan mentioned above. Falling behind on one loan to get ahead on another doesn’t make sense.
- Do you have additional money available each month (above the minimum payments) to go towards paying off debt? If you don’t, it doesn’t matter which order you’re paying the debts as you’re only making the minimum payments. You will need to either increase your income or decrease your expenses.
Choosing a Debt Payment Strategy
Let’s assume you’ve listed your debts and have some available cash flow each month to put toward paying them off faster than scheduled. When it comes to debt elimination strategies, a quick search on the internet will provide many opinions about how to do it most effectively. At this point, you have to figure out what strategy will work best for you. Advisors will advocate many different strategies including:
- Paying the highest interest rate balances first.
- Paying the smallest balances first.
- Paying the most “painful” ones first (i.e., owing the IRS, or a family member you have to see at Thanksgiving.)
- Paying “secured” debt first (since a failure to repay could cause you to lose your car, for example), then paying off the unsecured debtors.
Combinations of these strategies create an even more complicated repayment strategy. They’ll be given fancy names like the “debt snowball”, the “debt avalanche” and the “debt tsunami” (these are all actual names of payment strategies). Each one seems to be trying to outdo the previous. (For related reading, see: 7 Tips for the Do-It-Yourself Debt Manager.)
It’s certainly true that arguments can be made for any of these (and the many other) strategies out there, but which is best? Can we keep this simple and effective, or do we need to out think ourselves? And where do non-monetary issues, like motivation, come in? My recommendation is to list the debts smallest to largest and pay them off in that order. Generally this will be my advice to coaching clients. But there are always exceptions. For example, if a client had a $10,000 0% auto loan and an $11,000/21% credit card, clearly the credit card should be paid first, even though its balance is slightly larger.
When the smallest debt is paid completely, take the full amount you were paying on that debt and apply it to the next debt on the list. This is in addition to the minimum payment you’re making on that next debt. Yes, this does mean to ignore the interest rates being charged. However, in many cases the interest rate difference is not significant enough to ignore what works better in the real world - when emotions and motivations are taken into account. Let’s look at an example to see my point. In our hypothetical example, imagine having the following debts:
Maybe they’re student loans, car loans, or credit cards. The source doesn’t matter. The minimum payments total $1,000 and assume further that through the use of a great spending plan we have an extra $500 per month to put towards paying them off early. If you pay them using “smallest to largest balance” here is the result:
If you pay them using “highest to lowest interest rate” here is the result:
In both cases, it took 19 months to pay off all of the balances. The interest savings you would realize if you paid the highest rate first would be only $113.28. This works out to less than $6 for each of the 19 months.
Using the smallest balance first method, the first victory (i.e., paying off the first item) occurred in only five months. Think how great it would feel to get that first one out of your life. Then the second is paid off in only seven more months and the third is gone only two months after that. I see those victories as being huge in maintaining your motivation to keep going. It would take 14 months to pay off the first debt using the highest interest rate first method. If you can stay motivated that long without paying one off, feel free to do so and save the $6 per month.
Quick Victories Motivate
I’ve found that most people need the quick victories to keep going. More research is coming out to back up this theory. In August 2015, a study published in the Journal of Marketing Research found that paying off the smallest balance first led to more debt being paid off overall. “Winning what are known as ‘small victories’ by paying off small debts first can give consumers a real boost in eventually paying off all their debts,” write the authors of the study, Alexander L. Brown (Texas A&M University) and Joanna N. Lahey (Texas A&M University). “The reason is that meeting a small goal provides the motivation to then meet a larger goal.”
Obviously, the most important factor in paying off your debts is to pay as much as possible towards them, regardless of the order you pay them off. But if you have funds available to make extra payments, use them in a way to keep you motivated to finish the task. For most of us, it will be paying the smallest balance first. (For more from this author, see: 10 Reasons People Don’t Create a Budget.)