Debt Repayment Strategy

For those who are having trouble managing multiple debts, a debt repayment strategy can save money and also be psychologically rewarding. The first step in any debt repayment strategy is to list all of your debts with the balance outstanding, interest rate, and minimum monthly payment for each. For example:

 Description   Balance   Interest Rate   Minimum Payment 
 Car Loan   $11,000.00   3.5%   $200.00 
 Visa Credit Card   $1,900.00   12.99%   $43.00 
 Discover Card   $3,500.00   14.99%   $83.00 
 Student Loan   $9,500.00   8.99%   $153.00 

The next step is to establish a budget and commit to make the minimum required payment on all of your debts every month; the free budgeting tool at that I've been discussing in recent posts could help. In addition to committing to pay the minimum monthly payment on all of your debts, you also must commit to pay a little bit extra towards one of the loans. The extra amount will all be applied to the principal balance, as opposed to interest, and a lower principal balance results in less interest being charged over the life of the loan. While Mint can be used for tracking your debts and payments, other free online tools dedicated to debt reduction such as are available.

Which creditor should be paid the extra amount? All else being equal, this would obviously be the one that is charging the highest interest rate. However, many financial planners recommend making the additional payment towards the loan with the lowest balance. The reason for this is that you will see results sooner as the small balance goes down to zero. By seeing results faster, you will be more likely to stick to the debt repayment plan, which is better than starting with the higher rate/higher balance loan but ultimately abandoning the plan.

Perhaps a good compromise would be to sort all of your debts from highest interest rate to lowest, then move the loan with the lowest outstanding balance to the top of the list and pay off your debts in that order. The order of debts in the example above under this method would be the Visa Credit Card, Discover Card, Student Loan, and Car Loan.

Whatever method you choose, the next phase of the debt repayment plan after the first debt is paid off is important. The entire amount that was going toward the payment of the paid-off debt becomes an extra payment towards principal in addition to the minimum payment on the next debt on your list. For instance, in the example above if you were paying the minimum Visa Credit Card payment of $43 plus an additional $10 each month, after that debt is paid off, the $53 that has been freed up becomes an extra payment to Discover Card in addition to the minimum you are already paying.

This cycle is repeated until all your debts are paid off. As the number of outstanding loans diminishes, the extra amount being paid has grown substantially, similar to a snowball rolling downhill. This "Snowball Method" of debt-payment can help you achieve your goal of debt freedom.