This is the continuation of our financial planning guide if you have missed earlier topics here is a review. Before we go on to the next step in our financial planning process and to the second level in the financial pyramid we need to discuss debt reduction.
Reducing Debt Will Help Your Networth and Cashflow
If you have any debt, except mortgage and student loans, then getting out of debt should be the primary goal in your personal finance. Reducing your debt will automatically increase your Networth (Networth= Assets – Liabilities) and improve your cashflow, and cashflow is king when it comes to building wealth. Remember the magic of compounding and how it can help you in building wealth? Well when you have debt than there is the curse of compounding and it will work against you, because the compounding will be on the interest you owe, see Debt Free Adventures post on Interest amount paid for an interesting look at the cost of debt.
So paying off your consumer debt as soon as possible will dramatically improve your finances by clearing up cashflow and thereby increasing your networth. Imagine if you do not have to pay $500 per month towards your Credit Card debts and consumer loans, what can you do with that money? That money can go towards your retirement savings or college fund for your children; saving $500 per month over 5 years at 5% will get you over $33,000.
Debt Reduction Strategies
So we understand the importance of paying off debt, but how do we get started? Well there are two common methods to do this, one makes sense mathematically and the other emotionally.
Highest Interest First
This is the method you will hear from most “financial experts”. It’s a fairly straightforward method and is simple to follow:
- Take all your debt and list them in order from the highest to the lowest interest rate
- Make minimum payments on all your debt
- When you made the minimum payments go back to the highest rate and pay whatever extra you have left.
- When your highest interest debt is paid off you, you go on and pay the second highest interest off.
- Repeat this process till all your debt is paid off.
This method is the fastest and least expensive way to pay off your debt.
Doing the financially right thing does not always workout for some, if you did worry about the “right” financial decision you would not be in debt.
The Debt Snowball takes into account your emotions and therefore this method is slightly different, yet still easy to follow:
- Rank from lowest amount owing to largest amount and ignore the interest rates.
- Pay the minimum on all debt
- Pay whatever is left over towards the lowest debt outstanding
- When the lowest amount is paid off continue with second lowest.
- Repeat the steps till all debt is paid off.
Notice how this method does not worry about the interest rate, but rather the amount outstanding. The idea is that ones you pay off a debt it will provide you with some psychological encouragement and act as a reinforcer. This method could take a little longer and end up more expensive, however there is a lot of anecdotal evidence that it works. This strategy is proposed by Dave Ramsey in his book The Total Money Makeover. For a quick summary of the Debt Snowball see my review of The Total Money Makeover, and here is a more detailed review of Debt Snowball. This method is somewhat controversial, some agree with the method others do not, here is a closer look at Dave Ramsey as a financial expert.
It does not matter which method you choose to payoff your debt as long as you pay it off quickly. Know yourself and choose the method that you know will work for you and than stick with it.
The internet is filled it great information on how to get out of debt, Moolanomy’s Get out of Debt for Good is a good place to start. If you need more help and resources check out JD’s Get Rich Slowly Get out of Debt section. If most of you debt is Credit Card debt, My Life ROI has a great post on ways to avoid credit card costs.
Vertex 42 has an excellent debt reduction excel calculator that you can download and use. You input your data and choose which debt reduction strategy you want and it will do all the calculations for you, it’s a great tool to use if you are serious about paying off your debt.
Ones your debt is paid off or at least paid down we can start our wealth building process, which is the purpose of our financial planning guide.
Do you have other suggestions? Did you pay off a large amount of debt? If so what was your strategy and how much did it improve your lifestyle?