This is the first post in a series of posts dealing with debt, insurance, investments, etc. This is slow going due to all my other responsibilities, but more will be on the way. On to the meat of the article now!
There are several methods of eliminating debt. Debt consolidation is NOT among them. That’s a band-aid and as we all know, band-aids only SLOW the bleeding, not STOP it. Ask a doctor about the best way to stop a bleeding wound, from the inside out. The first step in doing this is to make a decision. Decide to get out of debt, that’s the easy part. Below, you will find several methods of doing this and a few suggestions on how to make it happen.
For the next few definitions, we are going to use the following example. These are by no means accurate and are just used for demonstration purposes.
- Credit Card – 12% Interest – $3,000 Balance – $40/mo
- Auto Loan – 5% Interest – $15,000 Balance – $500/mo
- 1st Mortgage – 6.5% Interest – $200,000 Balance – $1200/mo
- Credit Card 2 – 25% Interest – $2,000 Balance – $50/mo
Lowest Balance First
This method is for those that need immediate gratification. You pay all you can on the lowest balance debt you have while still paying your minimal on everything else. It works, but is not efficient.
- Credit Card 2
- Credit Card 1
- Auto Loan
- 1st Mortgage
Highest Balance First
This is similar to above except in reverse. This is even less efficient, but will work. Granted when most people choose this method, they don’t include their house as the highest debt.
- Auto Loan
- Credit Card 1
- Credit Card 2
- 1st Mortgage
Lowest Interest Rate First
Take your card with the lowest rate, and pay all towards it. Although it will help save on interest, your higher interest debts are increasing at an alarming rate.
- Auto Loan
- Credit Card 1
- Credit Card 2
- 1st Mortgage
Highest Interest Rate First
The reverse of above, but will reduce what you are paying on interest. Most people focus on the rate which is not the best thing to do.
- Credit Card 2
- Credit Card 1
- Auto Loan
- 1st Mortgage
Debt Stacking / Snowballing / Debt Acceleration
This is usually used with a combination of the above. What this does is, as you pay off your debts, takes that monthly payment and applies it to the next in line. Using the Lowest Balance First method above, it might look something like this:
- Credit Card 2 – $50/mo
- Credit Card 1 – $90/mo
- Auto Loan – $590/mo
- 1st Mortgage – $1,90/mo
Those payments are based on the above then adding the previous one to it. If you were to follow it, it would probably cut about 10 to 15 YEARS off of a 30 year mortgage. So tell me, how long would it take you to pay off a $200k mortgage paying $1,790 a month? That is the power of debt stacking!
Debt Snow-flaking
This one is interesting. I only recently found it in a Dave Ramsey forum post. Basically, it takes the above Debt Stacking method and applies what ever free change you have at the end of the month to which debt you are focusing on. That’s a great idea, and one I teach and recommend to my clients.
The best method to use, is the one you will follow. Mathematically speaking though, none of these are “efficient” by themselves, yet they all work to accomplish the same goal. If you run the numbers out, sometimes it’s better to pay the highest interest, then the lowest balance, then the highest balance, then the lowest interest, etc. To figure it out, you will need a spreadsheet program. You can use Numbers on Mac, Excel on Windows, or use OpenOffice on those and Linux. You can also use Google Docs. There are a few formulas below that will help.
I could show you how to do this via a spreadsheet, but in my many attempts to write it down, it became PAINFULLY obvious that I could not put it into words. Soooo, what I will do is work on an app for you all to use that will take the above methods and figure out the various ways and how much interest is expected to be paid/saved. No promises on accuracy now. I am only one man building and working 3 businesses.
In the upcoming posts, I expect to write a bit more on various types of loans, different methods of figuring interest, how sometimes paying twice a month is useless, etc.
Until then, good luck and keep an eye on my twitter page (link to the right) for future posts.