Our lives are controlled by our debts. What we owe controls how much of our hard-earned money we actually get to keep, limits our purchasing power, and can hinder us when we want to make large purchases by determining both the amount we can borrow and how much we have to pay to take out a loan. While it is a noble notion, living a debt-free life is just impractical for most people since most of us can’t afford to pay cash for a home or car.
We may not be able to go a lifetime without borrowing money, but we can be smart about how we pay it off. Here are two common strategies recommended by financial professionals.
- 1. Pay off debts with the highest interest rate first.
Interest is your enemy. Every cent you pay in interest is money that A. you didn’t borrow, and therefore didn’t use and B. is not reducing the amount that you owe. Therefore, you want to pay as little in interest as possible. The most effective way to do that is to pay off your debts with the highest interest rate first.
Identify which of your liabilities has the highest interest rate, regardless of the size of the balance, and plow as much capital as you can into servicing that debt, while making minimum payments on your other loans and credit cards.
This strategy will assure that you pay the least amount of interest (as a proportion of your debt) over the course of your loans, but it is not always the best plan to implement. Servicing debt can be a lot like dieting. You may be really gung-ho at the start, but if you don’t see results after the first few weeks, you may find yourself slipping back into old habits. That leads us to our second strategy.
- 2. Pay off your debts with the smallest balance first
Going back to the first strategy, what if your highest interest rate belongs to a $50,000 private student loan? You can double your payments on it, but it will still take several years to eliminate that albatross. Meanwhile, maybe you have a credit card with a $500 balance with a slightly lower interest rate. It may cost you more in total interest paid, but you’ll get immediate gratification by paying off that credit card right away.
That is the key to this strategy. Financial experts will tell you that the first strategy mentioned will save you more money in the long run, but at the same time, a plan is only so good as long as you stick with it. They will concede that attacking your smallest balances first may not be (from a pure dollars and cents standpoint) the most efficient way of becoming debt-free, but if getting that satisfaction from paying off a credit card keeps you excited about minimizing your debt, then it is worth it.
Under this plan, list your debts in order of balance owed, and work your way from the smallest to the largest. Send in the minimum payments on all the larger liabilities, while putting any extra you can toward servicing the smallest balance.
Employing these strategies can take you a long way toward improving your financial health, as getting rid of debt will improve your credit score, allow you to borrow money at lower interest rates and put more money in your own pocket.