A reader wrote in recently:
I have kind of a weird situation with our 2 credit cards, and wanted to see what you thought. We have one card (Citi) with a total balance of $4,800. $3,800 of this is a balance transfer that is at 2.99% until paid off. The remaining $1,000 is at 13.49%. Of course, all principal payments are applied to the lower rate debt first. Our other card (Chase) has a balance of $5,700, and is at 0% until September 08, when it goes to 8.99%. Which card do you think is best to “attack” first?
After reading this email, I thought it would be a good time to take a more general look at comparing the debts you owe as well as how to construct a healthy debt repayment plan. This is the kind of “nuts and bolts” personal finance that’s well worth sitting down for a half hour and doing every once in a while, as it can save you a ton of money if you have more than a debt or two.
Obviously, this only works if you commit to spending less than you earn. If you’re spending more than you earn – and thus building up debt each month – you’ve got a much more serious problem to solve before you should start a debt repayment plan.
Getting Started – What You Need
To get the ball rolling, you’re going to need a few items.
A few sheets of paper and a pen Even though I spend tons of time at the computer, I still find this to be a good exercise to do with a few sheets of paper and a pen. Doing this little task by hand adds to the concreteness and importance of the exercise – and there’s really no math to do by hand here, either, so you don’t have to worry about needing calculation tools.
The latest statement for every single debt you have You’ll also need the latest statement on every single debt you have: your mortgage, your auto loans, student loans you’re responsible for, any other outstanding consumer loans, credit card statements, and so on. Everything. Make sure that on this statement you can identify the annual interest rate (APR or APY, it’s not important to distinguish between the two for the purpose of this exercise).
Making the first list The first thing you should do is make a list with four columns consisting of the name of each debt you owe, the amount you still owe on that debt, the monthly payment for that debt, and, most importantly, the current interest rate on that debt. You should be able to get all of this information easily from the statements. The goal here is to get all of that information into one place.
Which Debts Take Priority?
Now that you have the list, you can put the statements off to the side – everything you need is now on this one sheet of paper.
Order all of the debts by their current interest rate. Now, go through that list and number the debts based on their interest rate. Give the highest interest a big number 1 off to the left, the next highest a big 2, and so on. Don’t worry about which debt has the biggest balance – that doesn’t actually matter when figuring out which debt is the most important one to pay off.
Look for ways to reduce the rates, focusing most strongly on the highest current one. Now that you’ve ordered the debts, go to the debt marked with a 1. Is there any way you can reduce that interest rate? If it’s a credit card debt, you could call the credit card company and ask for a rate reduction, or you could transfer the balance to another card for a lower rate. You might also be able to pay it off with a home equity line of credit or with a personal loan from your credit union. Maybe you can consolidate your student loans at a very low rate. The key is to lower that interest rate. Go through every one of your debts from highest to lowest interest rate and do your best to get each rate nice and low. Obviously, there are some rates you’re likely to be unable to easily change, like your mortgage rate, but see what you can do about most of the rest of them.
When you’ve reduced rates, make a new list reflecting the changes. As you get each rate lowered, update your list – cross off the old rates and write in the new ones, and likely cross off a few lines entirely and add new ones (if you consolidate or do balance transfers). If you wind up with two different interest rates on the same balance – after a balance transfer, for example – write down the interest rate that you’d be paying off first with any extra payments and ignore the other rate.
Once you’ve lowered all the rates as much as possible, rewrite the whole list so it’s clear, except order them directly by their current interest rate with the highest rate on top. This is your debt repayment plan – it will save you a lot of money if you stick with it.
What about debts that are set to adjust in the future? One aspect that often confuses people is how to handle debts that are set to adjust in the future. I generally ignore these adjustments and apply one simple rule of thumb: it’s always best to be in the best possible situation one month from now because the future is unclear. You may end up consolidating those debts, or maybe a windfall will come suddenly. Because of that uncertainty, look at the short term when repaying your debts and ignore possible future adjustments – it’ll make the planning easier and guide you down a path that, no matter what, is at the very least close to the best possible plan and often is the best possible plan.
Yes, I’m aware that situations can be constructed where it’s arguably better to worry about the adjustments early, but given the uncertainty of what may come and also the high level of confusion one adds to the discussion in order to shave off a few extra dollars, it’s not worth the speculation. Build a plan – one that’s simple, makes sense, and is either optimal or very close to it – and stick with it, and you’ll be just fine.
How Do I Use The Plan?
Direct all of your extra payments towards the top debt on the list. Each month, make minimum payments on all of the debts on the list except for the top one. With that top debt, throw everything you can at it. Make a double payment or a triple payment or more. This is a great time to use the snowflaking strategy – whenever you come into a few extra dollars during the month, due to living cheap or a little unexpected windfall, immediately apply that cash to the top debt on your list.
When a debt vanishes, cross it off and feel good about it! Over time, you should be eating away very quickly at that top debt, and (hopefully) before long you’ll be able to eliminate it. Cross it off the list, celebrate a little, then start hammering away at the new top dog on your list.
When Do I Need To Update The Plan?
Update the list when you acquire a new debt. Whenever you get a new debt, it’s going to need to find a place on your list. Stick it in there wherever it belongs based on the interest rate.
Update the list when one of your debts adjusts to a new rate. Whenever a debt of yours adjusts in interest rate, cross it off the list, then add it back in just like a new debt where it belongs based on the new interest rate.
After you do this a few times, it’s useful to rewrite the list so that everything remains clear on it, but it’s fun to hold onto the old one (with some crossed-out debts) to remember where you came from.