Our last discussion on how to get control of your money focused on building up your cash reserves through several phases until you have reached a fully funded Emergency Fund. A part of progressing through all phases includes attacking debt, as I stated in the last post:
In other words, once you have built up an Emergency Fund to take care of possible emergencies using cash, then it’s best to prioritize addressing your debt situation before progressing further towards a fully funded Emergency Fund. But how exactly should you address your debt situation? What should your pace be? Should you simply throw every extra dollar at your debts and eat only “Rice & Beans…Beans & Rice” as Dave Ramsey advises or should you take a more comfortable pace? Should you address high interest debt first or should you address the biggest debts first? How about just starting at the smallest debts instead to build momentum? These questions bring up two considerations when deciding how to tackle debt – Pace and Method. We’ll discuss both of these below. One additional note before we dive in – The type of debt that I’m referring to in this post includes all consumer debt and student loans. Whether or not you include your mortgage in your immediate debt payoff plans is up to you.
Deciding on Pace
When I talk about “Pace” I’m referring to how much of your surplus you dedicate towards paying down your debt each month. Assuming that you have enough saved to cover possible emergencies, pace really comes down to a matter of urgency and comfort. The more adamant you are about getting out of debt, the more money you will want to commit towards that objective. Accordingly, the more money you commit towards your objective of getting out of debt, the less “comfortable” you will be, since more money committed towards debt will mean less money available for comforts such as movies, eating out, vacations, and the like. So the question to answer when deciding pace is how badly do you want to get out of debt and what comforts are you willing to sacrifice to get there? If you have high interest consumer debt and/or large student loans, the matter is pretty urgent. It really doesn’t make sense to throw away money every month in the form of interest payments for the sake of a few creature comforts that can be sacrificed temporarily. So, my guiding advice when deciding on pace is this – Sacrifice as much comfort as possible in order to get out of debt as quickly as possible! Obviously, this doesn’t mean sacrifice to the point of harming your health (e.g., foregoing a visit to the doc if you’re not feeling well) or relationships (if you and your wife need at least one date night a month to stay sane, then do it!), but it does mean be absolutely honest about what you can give up temporarily in order to attack debt with as much urgency as possible. Our personal debt payoff pace included throwing as much money as possible at debt for about 5-6 months, which included paying off a $6,000 credit card balance within a few months. During this time we sacrificed vacations, dinners out, and personal items that we wanted to purchase. After about a 9-month break in pace while transitioning from living in Hong Kong to Eastern Europe, we hit the remaining debt hard again until we were debt free! That roughly 15-months of focused sacrifice pales in comparison to the freedom we now enjoy.
Deciding on Method
Now that you understand what is an appropriate pace and have committed to how much you can sacrifice during your journey to debt freedom, it’s time to decide the method by which you will attack your debts. Here you have a few options – 1) Paying off debts according to highest interest rates, 2) Paying off debts from smallest to largest, irrespective of interest rates, and 3) Paying off debts according to largest monthly payment. Mathematically speaking, attacking your highest interest credit cards first makes the most sense, since these debts are the most expensive for you to service monthly. The problem that you could run into with this method is having a high interest rate credit card that also has a high balance. In such a case, there could be the temptation to become discouraged by the amount of time it may take to finally knock out that particular debt. If seeing debts fall quickly is motivating for you, then Method #2 – commonly called the “Snowball Method” as a methaphor for the momentum that this method encourages over time – might suit you better. With this method, you pay off your debts in order of smallest to largest. Each time a debt is paid off, you use the money that was dedicated towards eradicating that smaller debt and add it to the monthly payment of your next debt. Eventually, your debt payments become such a large “snowball” that your biggest debts are easily conquered. Many people prefer this method for its motivation factor, but the problem that you may run into with this method is large monthly payments on fixed debts such as car notes or personal loans clogging up your cash flow and hampering your debt payoff momentum. This leads to the third possible method – Attacking debt according to the size of the monthly payment. This method allows you to free up additional cash that can be used to attack other debts, but may not be the best approach mathematically and may also mean that you will have to attack a larger debt in order to free up that large monthly payment.
So which method should you select? My guiding advice here is this – Attack whichever debts annoy you the most first! If the thought of high interest irks you to no end, attack those debts first! If the thought of itty bitty debts here and there annoy you, then attack those debts first! And if you cannot live with the thought of a huge monthly payment eating into your cash flow and hindering your momentum, then attack those big payment debts first! And if all three annoy you just about equally, then don’t worry too much about following an exact method, just pay off your stinking debt as quickly as possible! Personally, we used a combination of all three methods. We paid off some smaller debts first, then got rid of a big monthly payment debt and used that money to help pay off a high interest $6,000 credit card mentioned previously. During our concluding 6-month pay-off stint, we attacked another large payment and used that money to get rid of a remaining high interest debt and our biggest monthly payment debt.
To wrap this up, the pace you should adopt is one that is as urgent as possible. The method you should adopt is one that helps you stay motivated and gives you momentum. An urgent pace and appropriate method (for you) are a powerful force towards debt freedom. Now, get to it!