There are several debt reduction approaches that have proven successful for many people. We can concentrate or focus on paying the smallest debt, the largest debt, or the debt with the highest interest rate. Or we can use debt consolidation and simplify the situation with a single bill each month.
To compare the methods, let’s assume the following debt situation:
Paying the Largest Debt First
With this method, the idea is to eliminate the largest debt. If we have a limited amount of money to apply to debt each month, we can only increase the car payment amount (the largest debt in the example) by reducing the payments for the credit cards. We’ll reduce each of them by $50.00 which will free up $150.00 to add to the $200.00 car loan payment.
Note: If you consider this approach, be sure that your loan allows you to increase the payment amount, and that early payoff is accepted. With some loans, there is actually a penalty for paying the loan balance off ahead of schedule.
With this approach, the car loan balance is reduced faster, and the credit card balances are stretched out further. When the car loan balance is paid off, we would concentrate on the next largest debt (Credit Card #1) by adding the full amount that was being paid on the car loan to the payment amount we’re making on the credit card each month. This would increase the payment for Credit Card #1 to $550.00, which would pay off the balance very quickly. Once the balance on Credit Card #1 has been eliminated, the amount from that payment would be added to the payment for Credit Card #3 which is the next largest debt. This continues until all debts have been eliminated.
This method has the benefit of reducing a large debt and the interest that applies to a large debt, but it also takes longer than the other methods. Even with the increased payment, it will take over two years to pay off the car loan. Meanwhile, we would be paying interest on the credit card debts and perhaps accumulating more debt.
Paying the Smallest Debt First
This method tends to be a favorite because small debts can be eliminated fairly quickly. In the example, the smallest debt is Credit Card #2, and we would use a similar approach as before. The car loan payment must be at least $200.00, so we would take $50.00 from the original payment amounts for Credit Card #1 and #3. The payment for Credit Card #2 would now be $200.00, and with this payment amount the balance is eliminated in about three months.
With the balance on Credit Card #2 eliminated, the amount from that payment is added to the payment for Credit Card #3 which is the next lowest balance. Credit Card #3’s payment would become $250.00, and the balance would be eliminated in four months. Once Credit Card #3 is paid off, the $250.00 payment would be added to Credit Card #1 which increases that payment to $450.00, and the balance is paid off in just three months. When the balance for Credit Card #1 is paid off, $450.00 is then applied to the car loan (if permitted).
Paying the smallest debt first gives us some momentum and we can see results very quickly. With this method, all of the credit card debt was eliminated in eleven months. Of course, our ability to do this depends on controlling our spending and not adding any new debt.
Paying the Debt with the Highest Interest Rate First
If we decided to pay down the debt with the highest interest rate first, we would increase the payment on Credit Card #2 (which also happens to be the smallest debt), and then when that balance was paid off we would add that payment to Credit Card #1. When that balance was paid off, we would concentrate on Credit Card #3, and after that we would concentrate on the car loan. If you’re being plagued by high interest rates, this may be the preferred approach. There are people who are paying interest rates near 24% on credit card balances. For them, this method might be worth considering especially if there is a high balance.
With debt consolidation, all of our debts are combined into a single payment. It usually involves a separate loan for the total amount of our debt, and the money from the loan is used to pay off all the other debts. Our other debt balances are paid off, and we have one large payment to make on the new debt. Sometimes this is handled through a third party that we pay a single amount each month, and they in turn pay the companies that we owe. The third party charges a fee for handling this process. The additional fees are often added to the interest charged, so we need to thoroughly understand the costs with this approach.
I’m not fond of the debt consolidation method because it’s more of a convenience approach, and requires a great deal of discipline to succeed. Once all of the previous debt balances are removed, people often continue to charge and accumulate more debt. The situation in the end is worse than it was in the beginning, and the root of the problem wasn’t addressed.
Any of these debt reduction methods can be used successfully to eliminate debt. The goal is financial independence, and establishing a plan to eliminate debt is a great first step.
Thanks for reading.