Wednesday, June 6, 2012

Dealing with Debt

When pruning shears won't cut it
Estimated Planning Time: 1 hour
Materials: Results from Creating a Balance Sheet, Tracking Your Spending, and Creating a Budget
Project Difficulty: Easy

I have to admit up front that my personal experience with consumer debt is limited. Through a combination of upbringing and circumstance, I have never had any debt other than a mortgage. I have, however, spent a lot of time thinking about how I avoided it while others did not, so I hope I can add something to the subject.

 You should already have a good picture of your debts from creating your personal balance sheet. Now go through those debts and list the interest rate and the amount of interest you are paying (or accruing) each month. You will notice that your mortgage, if you have one, probably carries the lowest interest rate. Although paying off your mortgage is a great and a worthy goal, it should not be your highest priority in my opinion. On the other hand, credit card debt, followed by car loans and then student debt, should be a very high priority.

There are two main ways of paying off consumer debt, one is emotional and one is mathematical. Looking at your debt, you might be tempted to pay off the highest interest rate debt first. Or even take out a different type of loan (like a home equity line of credit) with a lower interest rate and use the money to pay off your high interest loan balances. Mathematically, this make sense, you will end up paying less in interest expenses by doing it this way. However, human beings are not 100% rational creatures to the bewilderment of economists everywhere. People sometimes start down this path and run out of steam.

The second, more emotional method is the debt snowball. Proponents include Dave Ramsey and other financial gurus. Basically you pay the minimum balance due on all debts except the smallest debt. You start to pay off the smallest debt as fast as possible. When it’s paid off, you start to pay off the next smallest debt and so on until all your debts are paid off. This method has the benefit of keeping you motivated as you pay off each debt. Think about it this way, if you were the mathematical type of person in the first place, would you have gotten into so much debt?

In the end, you should choose the method that you will stick with over the period needed to pay off these debts. Use your budget to determine how much you can use to pay off your debt each month and then run the numbers to see how long it will take under various methods. Once you decide on something, try to automate the process through online banking to make the calculated payment as soon as you receive your paycheck.

Two final notes – before you aggressively pay off your debts you should have at least a small emergency fund.  If you start paying off your debt without one, any setbacks will have a larger impact and will set you back further financially and psychologically.  Also, keep in mind the values and judgements that got you into debt and decide to change them.  This process will probably be difficult and painful, but ultimately very valuable.

1 comment:

  1. There are two main ways of paying off consumer debt, one is emotional and one is mathematical. Looking at your debt consolidation for payday loans


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