Broker Check

The Smart way to pay off debt

Jul 10, 2015

To pay off your debt as quickly as possible with the least cost to you is everyone’s goal.  You can do this by following some simple guidelines.  The problem is that many people work hard to pay off their debts but don’t make the right decisions as to how to pay them off because they haven’t learned the right strategy.  Many who make this mistake are not at fault.  There are some advisors that just give bad advice.

Last year there was a radio ad promising to teach you how to pay down your debt, no matter how big, with only the money you already make.  This isn’t possible for everyone.  Some people do owe more than they can ever possibly repay.

This system starts off in exactly the right place.  The first thing to do when faced with debt is to stop the bleeding.  Lay out a budget, use coupons, even cancel or downgrade services like your phone and cable.  The materials teach the wrong message however when it comes to what debt to pay in what order.  This advisors system recommended that you pay off the smallest debt first.  Once the smallest debt is paid entirely apply that monthly payment to the next smallest debt and so on until they are all paid off.

Responsible advisors and research from the University of Michigan's Ross School of Business claim that such advice actually makes it harder to dig out of debt.  People like to pay off their smaller debts first because of a phenomenon called debt account aversion.  When an account is paid off you feel accomplished.  Just like when you look at your list of to-do items and you do the easiest items first.

The problem with this tactic is that it does not take into account issues like interests rates.  If the smallest debt also has the highest rate then it does make sense.  Paying the debt with the highest rate first is the way that will cost you the least amount of money; thereby allowing you to pay off the total debt the fastest.

Lilly of Silver Spring, MD has 3 credit cards and has agreed to share her situation as an example.  Card A ~ $1000 at 6%

Card B ~ $2000 at 18%

Card C ~ $5000 at 28%

If her Minimum payments are 3% of the balance and she has $400 to apply to her debts each month paying off the smallest card first she pays her last bill in month 28 costing a total of $10,668.60.  If she pays the highest interest first her last payment is in month 23 costing a total of $8,919.95.

Many credit cards include a chart in their bills comparing the total payoff amount when paying only the minimum with some slightly larger amount showing how much you can save.  This causes some people to try to pay off a little extra to each of their creditors each month.  Although this will save you money in comparison to just paying the minimum on all of your bills it will still cost you more than focusing on the highest rate debt first.

You could save yourself a lot of money if you just take a few minutes to lay out your plan on paper.  Most people hate to do this because it means they have to look at all of their debt in one place.  Organize your list in order of highest to lowest interest rates.  Begin by taking any money you can put toward paying down your debt above your minimum payments and put it toward the single debt with the highest interest rate.

Now that you have your list and you have gotten started, don’t slack off.  Over time as you pay off more keep in contact with your creditors.  Call and ask them to lower your rates.  The worst they can do is say no.  As the amount of debt you owe decreases in relation to your available credit, your credit score will increase and they will do more to keep you as a paying customer.  Don’t forget to keep your list up to date and continue to work on that highest rate debt.

Debt can be a useful thing in some situations like buying big-ticket items, a house or a car but it is not the way to pay for your day to day expenses.  Make sure you use debt responsibly so this lesson is one you don’t have to learn the hard way.