The Hard Hit School has likely taught you one of the four decision-making approaches used to pay off or settle debt. Armed with this knowledge, you are ready to tax your home or business down a path that will only be wrong about 75% of the time.
Debt can be good. It generates credit, allows expansion, closes gaps and finances education. Too much debt, on the other hand, can affect the family budget or the company. Once you’ve made the decision to reduce debt, this short guide will help you determine the best way to achieve your goal.
In very simple terms, to reduce debt, you must first be able to pay all the minimum payments on each debt and other monthly expenses. After that, additional “debt reduction” funds must be available to apply to one of the debts with the intention of eliminating it. Additional funds can be in large amounts or in small amounts over time. The size of the money pot is less important than the process. A bigger jackpot will help you reach your debt reduction goals faster; but a smaller pot, used correctly, will get you in the right direction.
The question is: If you have multiple debts (say … a home mortgage, a car loan, and a credit card), which one do you pay off first? There are four decision-making approaches to help you identify which one should be paid first: interest rate approach, equilibrium approach, cash flow approach, and risk reduction approach.
Interest rate approach:
Most likely, the demagogues of modern mythology have taught you the first of the four approaches through magazines and trade magazines or on radio and television. Pay off the debt with the highest interest rate. Therefore, if the mortgage has an APR of 7.4% while the vehicle loan is 6.0% and the credit card is 5.5%, choose to pay the debt reduction funds towards the loan with the highest interest: the mortgage.
The reasoning for this approach is sound and the math is simple. Not bad; it is simply incomplete as it represents only one tool in your toolbox to be used when your goal is to reduce the total interest paid. And just as a hammer is a wonderful tool, it doesn’t help much to remove a screw or cut a board in half.
Balance approach:
The beauty of debt reduction is the snowball effect that allows future debt reduction payments to be much higher than initial payments. Once you pay off the first debt, all other things being equal, you can now add the monthly payment you were paying on that debt to your original debt reduction payment, which can now be applied to the second debt. The balance approach, then, guides you to pay off debt with the smallest balance left on the loan when your goal is to reduce the amount of debt. So, if the mortgage balance is $ 258,000, the vehicle loan is $ 3,500, and the credit card is $ 8,000, pay off the vehicle loan first. This will allow you to combine the payment you were paying on the vehicle loan plus your additional debt reduction payment for the next debt, be it your mortgage or credit card.
Cash flow approach:
The only consistent thing in life is “change.” Just as you must be flexible in life, you must strive to add more flexibility to your finances. The cash flow approach teaches to reduce the loan which will reduce the monthly cash flow; that is, the amount you must pay each month as the sum of all your minimum payments. Mortgages and auto loans are typically installment loans, so even if you make a large payment above the minimum this month, you will still owe the same minimum payment next month. By contrast, credit cards, lines of credit, and interest-only loans adjust the amounts of your monthly payments based on the balance owed. So if the minimum monthly mortgage payment is $ 2,100, the vehicle loan is $ 650 and the credit card is $ 200; pay first with your credit card.
As your credit card balance is paid off, the minimum payment amount will decrease, causing less cash to flow out of your finances. This allows the most flexibility in case things get worse, opportunities arise, or plans change.
Risk reduction approach:
Lenders rank debt based on risk exposure, and so should you. Although your plan may be to completely eliminate all debt, plans change. At some point in the future, you may once again find yourself in front of a lender looking for another loan, perhaps to refinance a loan at a better interest rate. This will most likely happen before your total debt elimination plan is fully realized. Prepare for that possibility now by paying off your subprime debt first to reduce your overall accumulated risk so that lenders are more likely to make that future loan to you.
Lenders first classify debt as “secured” and “unsecured.” Secured debt is backed by collateral that the lender can recapture or enforce should it fail to honor its end of the bargain. This can get complicated as lenders further classify secured debt based on the value of the collateral, how the collateral typically appreciates / depreciates, and the ability to resell it. For this reason, a building in good condition is a better guarantee than an undeveloped land, and both are better than a vehicle that, in turn, is better than a boat. The better the collateral, the lower the risk associated with the debt. As you may suspect, unsecured debt is not guaranteed. You have nothing to back it up except your word that you will pay. Unsecured debt is therefore the most risky debt.
Continuing with the previous example, using the Risk Reduction Approach: pay the credit card first, then the vehicle loan, then the mortgage.
The best approach for you:
As you can see, each approach can produce a different answer as to which debt to reduce first. Unfortunately, just as there are no magic wands, there is no best approach. All four approaches have great merit and can produce the “correct answer.” Ultimately, it is you who must decide the prudent financial management solution to achieve your goals. Run the analysis with each tool. State the results for your particular situation. Balance what you find with your personal strengths and weaknesses as you weigh possible future scenarios. So, make up your mind! No decision you make to reduce debt will be wrong, it will simply minimize the total interest paid, reduce the amount of debt owed, add more flexibility to your finances, or prepare you to seek another loan. Whatever decision you make, do it today.