So I hope your expectations for this post are high- as I'm loving this topic! So to start us off, here's a quick test to see where you on your journey to becoming a debt defying mogul. Also there are no wrong answers so don't be afraid to pick your strategy...
Debt Repayment Quiz:
What are your strategies for handling outstanding debts (credit cards, student loans, car notes, etc.)?
A. Pay on each debt equally, hoping to slowly work on your overall debt.
B. Just pay the minimum on each item- eventually the credit card companies/student loan financers will forget about me, right?
C. Work on the lowest debts first, watch the results 'snowball'
D. Focus on your debts with the highest interest rate and work outwards from there.
Okay, so I lied to you. I know, probably not the best way to start a post, but I will argue that there is a WRONG-ish answer, which I hoped you spotted right away. B - just pay the minimum. I'll make the case for when it may make sense for that to be your repayment strategy, but let me just say- for most folks it's likely not the right one.
Where ever you are on your personal finance journey, working on paying down your debt is probably one of the biggest hurdles. According to the US Census Bureau, 69% of American households are in debt. When I read that I was surprised by the fact that 31% of Americans have no debt- not the 1% folks, but 31%! Which means there are quite a few people out there who have embraced the frugal lifestyle of avoiding credit card, or car debt. Now I personally have dreams of the day when I'm part of the 31% of Americans who are debt free. I'll be real with you, on that day I'll be all like...
|Not what Ms. Frugal Rock actually looks like...|
Until than, I'm continuing to work on my debt repayment strategies so I can join the ranks. According to the US Census Bureau the average debt load is $70,000, which again, while high, was not as shocking of a number as I anticipated. There was a time where we had student loans, car loans and our home loan, which altogether was easily over $100,000. Using some helpful strategies I was able to work on paying off both my student loans and vehicle loans, and as I shared in this recent post, am actively working on that home loan.
But wait, you may say, to have enough money to pay on my debt, I need to have additional income. The general strategy for paying down your debt and saving, is diabolically simple- which is why I think you can be a debt defying mogul, with even just a few changes to your current way of living. So here goes, the basic premise to save $ is... to spend less than you make. Mind blowing, right? Not really- which is why I think anyone can do it! I've been asking a lot lately, 'what's the best way to pay off outstanding debt?' and found 4 common strategies for debt repayment. I will walk you through each one and than you can decide for yourself, which strategy works for you!
'Keep it at the Minimum'- Eventually the credit card companies will forget about me, right?
What is it?
So this is the strategy that is the least effective. Student Loan repayment plans can be up to 10 or 15 years, car loans can be upwards of 5 years and credit cards will allow you to keep paying the minimum for... well just about ever. So what makes this strategy, generally the worst? It has to do with the interest rate accrual. Loans and credit cards are an effective business model because the companies lend us money, and they charge us a % of interest that we need to pay on the value of the loan until it is paid off in it's entirety. They wouldn't keep lending us money if they didn't make a killing off of us anyway!
When does it make sense?
If you are truly living paycheck to paycheck, it's better to pay the minimum than let late fees add up. It can be overwhelming to get the repayment notices in the mail (or in your inbox) but it's better to tackle them head on, than to pretend that they don't exist. As you start to take a closer look at your finances, start a budget and track where your spending is going. You may find that there are areas that you are spending more than you anticipated. You may have room to cut back- if that's the case you can you use those additional savings to try out the more 'advanced' debt repayment strategies.
The other argument for paying the minimum is often applied to Student Loans. Some careers- think public service, or in my case, social work- offer a student loan forgiveness plan if you are working in a specific type of job post graduation. The plan I qualified for required that I pay the minimum monthly payment for 10 years- without any lapses or late payments. 10 years is a long time to be perfect, Federal Government! What I found when crunching the numbers was that I would pay more money in the long-run to keep paying the minimum, even if it meant eventually the loan would be 'forgiven'. Basically, it was more cost effective for me, to work on paying it off sooner. So while loan forgiveness looked good on paper and might make sense for someone with greater debt loads, it pays to crunch the numbers to see if it would actually be a long-term cost effective option for you.
'Chipping Away'- Pay on each debt equaling, hoping to slowly work back that debt load...
What is it?
Definitely better than merely paying the minimum, this strategy means paying slightly more on all of your debts across the board. Say you've go an extra $500 to spend each month and you are putting it towards paying down your debt instead of say...going out of town for the weekend. You take that $500 and spread it evenly over all of your outstanding debts, $100 additional towards student loans, $100 extra towards your car payment, etc.
When does it make sense?
If you are trying to make sense of your debt but aren't sure where to concentrate your $, this may be a good starting point for paying over your minimum payment amounts. If you have similar debts with similar interest rates, think 3 different student loans with similar rates and similar amounts this may be a good strategy for you. If you are a hand's off personal finance person, and want to set your monthly payments and forget it- this is likely the best strategy- however it may not be the most effective, or the most rewarding plan to try.
'David Ramsey's Snowball'- Pay down your lowest debts first- watch the results 'snowball'
What is it?
If you haven't yet checked out the David Ramsey finance site, I would highly recommend it as a good place to start finding inspiration for your debt-free lifestyle. He championed a debt-payment system called the 'Snowball', which while not always the best option, is probably the most satisfying way to work on debt- particularly when you have a few loans or credit cards you are working on paying off and are overwhelmed by the shear number of them!
Here's how it works- take your lowest debt. In my case, in the not so distant past, I had 5 different student loans that I was actively trying to pay off. The highest was over $10,000 and the lowest was just over $1,500. According to the Snowball plan (and basic psychology), getting results can be one of the biggest motivators for sticking with a behavior. Achieving some sort of success give us confidence and encouragement to tackle the next endeavor. I paid the minimum on my student loans, across the board- except for that lowest debt amount, $1,500 and put all my extra cash towards that loan. In two months, I received notice that it was paid completely off, and was able to start on the next one. While my debt load was still much higher than I would have liked, I knew I was moving in the right direction and found myself pretty pumped about working on the rest of them.
When does it make sense?
One of the biggest downfalls of debt repayment, is not being able to keep the momentum going. Inevitably, you will have good months and bad months. Some months you will save more, and other months you will get hit with unexpected expenses. The 'snowball' method can make debt repayment feel a bit exhilarating as you watch your progress. If you are one of those folks who gets that 'shoppers' high, after buying a big purchase, this model may be the right one for you!
The Most Bang for Your Buck Model- Are you a debt defying mogul?
What is it?
So this one takes a little more homework on your end! Take a look at all your debts, compare interest rates, type of debt, etc. and than start paying additional on the debt that will cost you the most in the long-run. This is the debt that you should focus your attention of repayment on, since holding off on repaying it could hurt you the most financially. An example of this, again from my not so distant past, was my car loan. While if I strictly paid on my lowest debts first (my student loans) and paid the minimum on my car loan, this would have cost me hundreds over the course of a year. Why? My car loan, was not only a larger amount, but also had a higher interest rate. Yikes!
When does it make sense?
This is the all around best model (hence the name!). It takes a bit more time to sit down and compare all of your debts, loans and bills and decide where to focus your time and attention, but once you have a plan you can set your online repayments each month and forget about it. As much as you can make repaying your debts a normal, and natural part of your month to month budget- the better.
1. Avoid getting into additional debt- if you are working on getting out of debt, avoid starting additional debts. For the credit card users out there (I'll admit to being one of them!), be sure that you can pay them off each month. Strive for a $0 carryover balance month to month in 2016.
2. But what about emergencies? How do I avoid going into debt even when there are unexpected expenses that come my way? Make sure you have an emergency fund for those unexpected expenses- experts often say 3-6 month's expenses saved on hand is sufficient, but even $1,000 in your savings account can be a good buffer for all sorts of situations.
3. Hold yourself accountable- tell your partner or family/friends that you are working on saving and paying down your debt. Just by telling someone else about it, you can ensure you stay on track. Split your finances with a significant other or a room mate? Be sure to have money conversations with them- you will need them on board to keep saving!
4. Last but not least, be patient with yourself. It will take time to pay off your debt. It's easy to get discouraged and give up, before you even begin but remember that you have control over how you repay your debt. Time to make that repayment on your terms- not someone else's!