Out With The Old, In With The New: Create a Debt Repayment Plan

Throughout the month of December, The Simple Dollar is posting a daily series focusing on specific activities you can do right now to set the stage for a great 2011. Out with the old, in with the new.

6. Create a debt repayment plan.

Yesterday, we talked about the usefulness of cleaning up your debts. Doing this reduces your interest rates (and thus the total amount of interest you’re paying to the companies), reduces your monthly payments, and reduces your risk of identity theft.

Of course, now that you have this reduced set of debts with a smaller batch of monthly payments, you’re in a perfect position to start tossing some of that savings toward eliminating those debts. The faster you get rid of those debts, the faster you’ll be in complete control of your financial future and the less you’ll have to pay on the whole to companies in the form of interest.

The way to do that is with a well-thought-out debt repayment plan.

Getting Ready
Developing such a plan is easy. You simply need a list of your debts, their balances, and their interest rates. If a debt has multiple rates, I usually encourage people to use the highest rate for that debt.

If you followed yesterday’s plan of minimizing and organizing your debts, this list should already be in front of you.

Ordering Them
The next step is putting the debts in the order in which you intend to repay them. There are two different schools of thought as to the order with which to repay them.

The Dave Ramsey “debt snowball” method encourages people to order their debts by their balance, smallest to largest. The reason for doing this is so that you experience the “success” of paying off a debt as quickly as possible so that you have the motivation to keep going.

The mathematically superior method encourages people to order their debts by their interest rate, highest to lowest. This method will result in your debts being paid off the fastest, but it can often be a long slog, particularly if your highest interest debt is a very large debt.

I don’t really think you can go wrong with either method. They each have advantages and disadvantages.

Executing the Plan
There’s one final thing you need to have before you start this plan: how much can you throw towards it per month?

That amount should be at least as much as you were throwing towards your debts before you cleaned them up. Ideally, you’re doing a little more than that.

So, let’s say you were spending $1,500 a month making minimum payments on your debts. After cleaning them up, your monthly payments are now $1,100. You should still aim for putting $1,500 a month towards it.

Treat that total amount as a bill that is without question. You have to pay that extra amount. If you start to fudge on it, all you’re doing is ensuring yourself a debt-filled future.

So, you have $1,500 in debt payments and $1,100 in minimum payments this month. That means you have $400 extra. You just add that $400 to your payment on the first debt on your list that month, giving the balance of that debt a good whacking.

What will happen is that over time, you’ll see the balance of that first debt dropping like a stone. Soon, it will be paid off.

At that point, your minimum payments might be $1,000. You should still be using $1,500 a month in debt payments, so now you have $500 extra per month. Cross off that paid off debt and, now, apply that extra $500 to the new top debt on your list.

This is basically the procedure you repeat until you’re debt free. You just keep alloting a large chunk towards debt repayment each month. Each month, make minimum payments on all of your debts, then make an extra payment on the debt at the top of your list. Rinse and repeat and watch the debts melt away.

Today is your day for getting such a system in place. Get rid of those debts that are constantly draining your wallet each and every month.

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  1. Nick says:

    Don’t forget that the Snowball isn’t just for the warm fuzzy feeling you get when you pay off debts faster — you also free up your cash flow faster. You are trading a few points of interest for flexibility.

  2. Des says:

    I’m curious to know: People who have paid off all your debt, which method did you use? I’d like to see if one has actually proved more successful than another from actual debt-free folks. Anyone?

  3. sheila too says:

    For people with Apple computers, there is an inexpensive piece of software called Debt Quencher from No Thirst Software LLC. You can enter balances, interest rates, and the payment due date for each debt. Using that information, the program will generate a payment schedule for each debt, total interest paid for all debt, and the total of all payments for four scenarios: minimum payment, highest interest, lowest balance, highest balance. You can add an additional payment amount (that’s your snowball) and watch how the total interest paid goes down and the payoff schedule shortens.

    I bought the software in October, and looking at the effect of a larger snowball has really motivated me to increase my additional payment amount.

    There are also free calculators at the Bank Rate and other sites, but you would have to look at each debt and payment scenario separately.

  4. Briana @ GBR says:

    I like the Snowball method because it does make you feel like you’re making an accomplishment. Going for the gold in 2011!

  5. valleycat1 says:

    I ditto Brianna on the Snowball method (paying off smaller balances first). I don’t find long hard slogs very motivating… Also, I’d add the advice from D. Ramsay about having at least a small emergency fund in place so you don’t have to rely on credit to handle those unavoidable expenses that can crop up.

  6. Fawn says:

    I am in favor of paying off the smaller debt first. It is easy for me to lose motivation. I would also second the idea of having a small emergency fund in place. Most of my debt was/is due to poor savings. I should have all my debt paid off by September 2012. If I pay $50 more each month, I will have it paid off 5 months earlier!! :) Good luck, and it is possible, just keep working at it!!

  7. JJ says:

    Re: Nick… You’re spot-on. That’s a commonly overlooked argument for the snowball method.

    The highest-interest-first method is only “mathematically superior” if your primary goal is to get out of debt as quickly as possible with a minimum of interest paid.

    But if your primary goal is to free up cash-flow as fast as possible (i.e., to reduce that minimum payment–$1100 in Trent’s example), and it’s worth it for you to give up some time and interest in support of that goal, then the snowball method actually has the mathematical advantage.

    And that goal is perfectly valid, if you ask me. It’s great to have that freedom of not “having” to pay a particular debt’s required minimum. Even though you’re using that extra money to pay off the remaining debts, you’re nonetheless free to divert it towards emergencies if they arise, or to not pay it at all if you run into income trouble (disability, layoff, salary reduction, etc.) Well worth the often small trade-off, IMHO.

    JJ

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