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.