Many people often struggle with coming up with a plan to get rid of their excess debts. Not having a workable plan is probably the biggest reason many people fail. But I also suspect most people never even get to the point of making a plan because they don’t have the extra money. That was always a big barrier for me. That’s why I think it’s key to make a plan and take action when you finally do bring in some extra money.
Let’s say you’ve just come into some extra money. Maybe you got a nice bonus at work, won the lotto, received a small inheritance, or got back a big tax refund. Now you’re looking over at your excess or unwanted debts and thinking you’d like to use some of this extra money to pay off the debts. What should your plan be? How should you go about deciding what to pay off first?
First of all, good for you for having the discipline to use this extra money towards debt repayment. It’s often that found money like this gets used on more spending. And many people often feel the need to splurge since they’ve finally found some extra money. I can’t say I blame them. I know the feelings of finally making some money after having gone without. You definitely want to reward yourself.
But part of becoming mature financially means you’re able to delay gratification and put off current wants for the sake of future needs. Okay, enough of that. On to the plan.
Assuming you’ve already established some sort of emergency fund, here’s how I’d go about deciding which debts to payoff first:
1. Make a listing of all your debts. Break out all of your statements and any old paperwork related to your debts. The point is to determine what your debts are, who you owe, and how much you owe. You might also want to pull a free credit report from annualcreditreport.com and look at all your open accounts with unpaid balances. You can get your free credit report from annualcreditreport.com once a year from each of the three credit reporting agencies. Once you know your debts, write them all down on a piece of paper, or build a spreadsheet listing using Microsoft Excel or my favorite, Open Office’s Calc.
2. Focus on the Unsecured Debts First. Generally speaking, you’ll want to focus in on your unsecured debts first. These are debts like credit card debt, medical bills, personal loans, pay day loans, and unsubsidized student loans. All these debts usually have high interest rates because they have no assets (or security) attached to them. These high interest rates are costing you a lot, and since there’s no asset as a result of the debt, the loan isn’t bringing you much future value. In most cases, you’ve borrowed to pay for something you’ve immediately consumed. Once you’ve identified what your unsecured debts are you can then assign a priority to them. That’s what we’ll do next.
3. Pick a Debt Pay Down Strategy that Suits You. There are many ways to go about paying off your debt. Don’t get too confused by all the methods. Just pick one that seems right and just start applying it full force. Many people never get around to paying off their debts because they’re overwhelmed by all the choices available to them: strategies, methods, products, etc. Here’s a couple of methods that make sense to me and I’ve seen success with:
- Use the “Debt Snowball” Method. This method was made famous by Dave Ramsey and it’s worked great for millions of people. This method helps you determine which debt to pay off first by having you list them in order of total balance, starting with the smallest. The reason this plan works for so many people is that you see success quickly and the success builds upon itself, like a snowball, to help motivate you towards getting rid of all the debts. If this sounds like the plan for you then I say go for it. Start out with the smallest debt first and attack it full force with your new found money. If there’s money left over, move to the second debt, and so on.
- Use the Highest Interest Rate. If you’re a numbers person and you strictly want to take the path of least mathematical resistance then you need to prioritize your list of debts by interest rate on the loan. Start with the debt paying the highest interest rate (it’s costing you the most money) and attack it full force until it’s paid off. Then, move to the second highest interest rate, and so on.
I hope this summary will provide some guidance for you when you come into that big pile of money and decide to rid yourself of excess debts. Good luck. For further reading on this topic be sure to check out How to Prioritize Your Debts for Payoff.
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I don’t understand your thing about focusing on unsecured debt first. If it has a higher interest rate, okay fine, but why not just pay off your debts in interest rate order? Everything else equal, a person should prefer to pay off secured debt first, since not paying off those loans could, in some circumstances, result in loss of the asset.
Frank – I added that part in because I don’t think enough people understand the types of debt and why high-interest debt exists. Plus, this article is about deciding which debt to pay off, not just which one to pay. I’m not advocating people stop making minimum payments.
My point was to show the high interest factor. Plus, the fact that generally those debts aren’t attached to anything providing value.
A house and a car provide continued value going forward. The cheesburger you bought 2 years ago isn’t providing anymore value. So you might want to attack that debt first. Just trying to add in some different ways of looking at it. I’m definitely not the best at articulating it.
I love questions like this. I think that if you have many debts, it’s definitely going to be more motivating to do the snowball and take care of the smallest-sized one first just to get it off your back. Also, it’s better if you can (at least, this is how it works for me) at least knock out one entire line of debt with your extra cash rather than part of one and part of another.
Another way to think about the question is what use of this extra money will give you the most immediate/beneficial leverage? It might actually be something other than paying off debt. Like if you need to buy a bike or get your car fixed or … something else that would provide more immediate and lasting benefit than just paying off a debt line. But I think usually it’s going to be wiping out some debt that will help most.
Hate to sound like a broken record, but the daily amoritization of Federal student loans is just evil, especially for a numbers guy. Not to mention their collections personnel are just plain mean….
And I’ve always believed debt-free is the way to go, but a sudden infusion of cash (lotto, bonus, etc.) does offer a little splurge, like a nice dinner out or something. Just keep the splurge to 25% of the total, and be wise with the rest.
PS, like the new pic!
I guess the answer to this question also depends on how big the windfall income is. If it is big enough, debt snowballing is really not necessary. It may even be counterproductive if you applied it. You may just go for the feel-good effect of debt snowballing and then spend the rest of the windfall. It is most important to make sure that an income windfall is actually applied to debt.
I would definitely pay off the ‘bad’ debt first – high interest consumer debt, etc.
At least with ‘good’ debt, like investments or your house, you’re getting some kind of perceived value.
We are getting ready to build a house our loan amount will be 188000. I have 26000.00 i could either pay on the house so we will only be borrowing 162 instead of 188, or i could pay on my credit card debt. Which would save the most money?
@Cyndi – Personally, I would pay off all my credit card debt prior to buying a house.
Putting 26k down on a house worth 188K isn’t going to eliminate the PMI. So, buying a house with that small of a down payment is going to cost you more than it would if you waited to have 20%.
I say just pay off your cc debt, then work on the 20% down payment.
Thanks for your help. I am pretty sure i will be paying the credit card off.
I have a work bonus and have been using the snowball effect to pay off debt. However with this bonus I could pay off the rest of my credit cards and with the left over money pay off a low interest secured loan. Or i can take all the money and pay off just 1 high interest personal loan.But still have the credit card debt. either way would allow me to put about the same amount that extra montly savings towards another bill. i just want to make sure i do the right think. I am thinking the rest of the credit cards and payoff that 1 low intrest credit line.