A couple of weeks ago, Amanda told me that she wants to be able to hold up one of those debt free signs that you see on social media which shows that you paid off $XX debt in XX months after she graduates. While this may not be the exact route that we go, I think it’s a common theme among those who set goals to improve their personal finances in the new year.
Paying down debt is one of the three most common New Year’s resolutions that people make along with sticking to a budget and saving more. I love that people are motivated to make their financial lives better, but just like I mentioned last week, setting the goal of “paying down debt” is a losing strategy. Any financial goal like this needs to be accompanied by a plan and system to make progress and actually make it happen.
I’m going to go through a lot of details and different options for paying down debt and following through on your resolution, but I want you to remember that the most important thing is to take action. Getting started is way more important than making sure that you’re doing things optimally (although I will talk about how to optimize since that’s how I prefer to do things).
I would rather you pick a financial strategy that isn’t exactly optimal but helps you to make progress than to remain stagnant and not make any progress at all.
Get Organized
Before you can create a plan for paying down your debt you need to know what you’re working with. Hopefully you know all of the outstanding debts that you have, but if you don’t then now is a great time to figure it out. You can start by pulling your credit report and reviewing what’s listed, which is something that you should be doing consistently anyways.
After you know what all of your obligations are you can find more specific information like up-to-date balances, minimum payments, interest rates, and due dates by logging into each loan provider’s website and pulling the most recent statement. Taking these two simple actions should help you get a much better grasp on your debt situation and will help you with creating a winning strategy that works for you.
What’s Your Plan?
Deciding that your goal is to pay down debt is fine, but do you actually know if it’s what you should really be doing for your personal situation? Paying down debt more quickly than you have to may actually not be your best financial decision and there may be better ways to use your money to increase your net worth.
If you’re set on paying down debt and not interested in learning about other options, then what’s your strategy? What debt are you going to focus on first? Are you going to try to make higher payments on everything?
It’s important to answer these types of questions and to have a solid plan in place as well as a system to follow through on that plan. Remember, “You do not rise to the level of your goals, you fall to the level of your systems.”
Start With High Interest Rate Debt
High interest rate debt can be a personal finance killer. If you have credit card balances or student loans or some other type of high interest rate debt, then you should consider making these your priority to knock out as quickly as possible. No matter what plan you come up with or what debt paydown strategy you want to use, you should start with making a plan for how you’re going to prioritize getting rid of credit card and other high interest rate debt.
Paying Down Debt Vs Other Uses of Your Money
One question you should ask yourself is, “Should I really be paying my debt down more quickly or is there a better use for my money?”
If you have high interest rate debt like I mentioned above, then the answer to this question is probably that you should be trying to get rid of it. However, if you don’t, and the debt that you have has a relatively low interest rate, then you might not be making the most of your money. Weighing the option of investing more of your extra funds each month versus paying down debt more quickly should be a consideration for those who want to do more with their money.
If your only debt is a low interest rate mortgage, then it may not actually make financial sense to pay it down more aggressively when considering the opportunity cost of what else you could do with your money. Investing your extra funds may make more mathematical sense over the long-term if your expected rate of return of your portfolio is higher than the interest rate on your mortgage. Obviously, this doesn’t take into consideration that many people are debt averse and feel like any sort of obligation is an anchor that’s tied to them.
It’s important to balance being financially optimal with your emotions.
Choose Your Strategy
When setting a goal to be intentional about paying down debt it’s best to have a specific debt paydown plan in place. You could just start making bigger payments on different debts, but there are much better strategies that you can use to be more efficient and effective.
Debt Avalanche
The debt avalanche is the most mathematically optimal strategy because it leaves you with paying the least amount of interest in the long run. Under this strategy you continue to make the minimum payments on all of your debts while making extra payments to the highest interest rate obligation. Once the debt with the highest interest rate is paid off, then you move on to applying your extra cash to the next highest interest rate and so on.
Debt Snowball
The debt snowball method is one that you’ve probably heard of since it’s the more popular strategy. The idea behind the debt snowball is to maintain motivation by getting more quick wins along the way by paying down the smallest balance first while moving to the largest balance.
Hybrid Approach
Of course, things don’t have to be black and white and you can combine these strategies. One way that I like to combine the two to help people make progress while getting some wins along the way is by sorting their debts by the highest interest rate first and then by the smallest balance. For example, if you have two credit cards at a 21% interest rate and two student loans at a 6% interest rate, then you would start with the smallest credit card balance, move to the second credit card once the first is paid off, and then move onto the smallest student loan balance.
You can read more about these debt paydown strategies here.
Get Started
There’s no one-size-fits-all approach to financial planning and everyone’s situations, goals, and thoughts on money are different. The same goes for paying down debt. While optimization can help to make your money go farther, it’s more important to get started than to get caught up in the weeds and not make any progress.
