Continuing on from our last blog entry about drilling down on your debt, the second in our blog series discusses the next important concept on how to prioritize debt repayment. After all, we have so many dollars in our billfold. There is no one size fits all strategy to this task. For most, it is a inhibiting and confusing undertaking. Debt may seem scary.
It can be hard to prioritize paying down debts when you have multiple payments for things like credit cards, student loans and maybe a car loan. But with a few simple steps, you can build a plan to tackle your debt strategically so that you can get rid of them more quickly leaving you with more cash each month for the things that are important to you.
Make a list
You can’t prioritize debt until you know how much you owe and to whom. Start by creating a list of all your debts, along with the following information:
- Name and contact information for each debt
- Type of debt (credit card, student loan, mortgage, personal loan, etc.)
- Total balance owed
- Interest rate
- Due date
- Minimum payment
- How long it would take to pay off the debt at the current payment (you might find this info on your billing statements)
- Potential benefits (like student loan interest may be tax deductible)
See if you can lower interest rates
Now that you’ve got a view of everything you owe in one place, look to see if you might be able to lower the amount you pay in interest. Some of your loans might have a fixed rate you can’t negotiate, but you may be able to lower the annual percentage rate (APR) on your credit cards, for example, simply by calling and asking. This can be particularly fruitful if you have a good credit score.
You may also be able to lower interest rates by transferring your credit card balances to a card with a lower APR or refinancing some of your loans. But in cases like these, you’d have to weigh whether any balance-transfer or refinancing fees would be worth it. Don’t forget that those 0 percent introductory APRs require you to make minimum payment and they don’t last forever.
If you’re thinking of consolidating or refinancing any federal student loans, you may end up losing some of their inherent benefits, like income-based payments or public loan forgiveness, so weigh your options carefully.
Extra money that can go to your debt
This will involve looking at your current cash flow and figuring out how much more of your take-home pay you can comfortably put toward debt without shortchanging important goals like your retirement contributions, emergency savings or things that are important to you today. If you want to free up even more money, you could also revisit your expenses and see what you can trim that can then be re-routed to your debt payments.
Pay high interest debt first
After you’ve updated your list with any newly lowered interest rates, put the debt with the highest interest rate at the top. It typically makes the most sense to focus your payment efforts on the debt with the highest interest rate first, because you pay more in interest every month that balance remains high. Most high-interest debt will likely be associated with credit cards.
However, you still need to pay at least the minimum amount due on all your other debts, so put those bills on autopay. Then devote any extra money to overpaying the highest interest rate debt first. Once you’ve paid off that debt, use the money you were putting toward it for the next highest interest rate loan or line of credit you have, and so on. This strategy is known as the avalanche method.
Once you’re done tackling your highest interest rate debts, you may find you have debts that hover around the same interest rate. If that’s the case, your next step should be to tackle the ones that don’t offer you any potential tax breaks — for instance, a personal or auto loan rather than a student loan. Among those, prioritize the ones with the lowest balances because they’ll be faster to knock out.
A note about mortgages: Your mortgage debt is considered “good” debt because your home is an investment that helps build your net worth; plus, it can help you get tax breaks. So, in many cases, a mortgage would be one of the last things you should try to accelerate payment on.
Keep future debt in check
Once you have a solid repayment plan in place, you’ll want to do everything you can to avoid getting yourself into debt again. By determining what led to the debt in the first place, you can get to the root of the problem and come up with a plan. If it was overspending, because you’re struggling to live within your means, it may be time to revisit your expenses and commit to sticking to a budget. If it was unexpected expenses, like a medical bill or a leaky roof, then it might be time to beef up your emergency fund so you don’t have to resort to credit cards in a jam.
As I said, this is a fundamental undertaking and obscure for many people. But it is so critical to the development and maintenance of your financial life plan and your ability to actually meet your savings and investment goals. After all, you’re doing the hard work of paying down debt. It’s important to know how not to build it back up again and move forward in Keeping Life Current.