Credit cards are a trap; debt comes easy and tends to stick around for longer than we want to. The ostrich technique doesn’t work here. We need to realize that we have a problem and we need to fix it. If you are here looking for ways to fix this problem, congrats, you are on the right track already!
Before we get to the nitty gritty lets do a practical example. Imagine that you owe money to 4 banks, all with different interest rates:
Bank A: $20.000 – 4.5% Interest rate
Bank B: $5.000 – 2% Interest rate
Bank C: $8.000 – 6% Interest rate
Bank D: $1.000 – 0% Interest rate
Which one would you pay first? Solution at the end!
So how do we pay off debt? Well…
To begin with we need the right mindset. To make sure we pay off that annoying debt we need to take a few things into consideration. First of all, when do we need/want to pay it off? Having a clear goal will help us put things into perspective. Once we have decided what debt we are going to pay first we need to embrace it and really focus on making it happen. If we print our goal and put it on a wall we will see it every day and we will be reminded of what we are working for. Having a clear goal helps a lot!
How many different debts do we have? Having different debts is like having different holes in a boat, we need to know where the holes are, how many and how big they are. If we fail to do this properly we might as well take some diving lessons because our boat will end up sinking real fast.
Do they have different interest rates? Continuing the boat analogy, the interest rates are the speed at which the water is getting into our boat. The majority of financial advisors will tell you that you need to pay off the debt with the biggest interest rate as it makes more financial sense in the long run.
Instead of paying the debts with highest interest some people like to use the ‘snowball effect’ where they start by paying the smaller debts first and then going for the next bigger one, that way they focus on reducing the number of debts they have. Even though this one makes less financial sense it is up to the person and what it is preferred.
To whom do we owe the money? If for whatever reason you owe money to a family member or a friend, this may be the kind of debt you want to pay first as it may have an impact on your personal relationships. These debts might be low on monetary interest but they are high on psychological interest.
So going back to the practical case explained at the beginning, following the 'highest interest rate' approach would:
Bank A: $20.000 – 4.5% Interest rate Pay second
Bank B: $5.000 – 2% Interest rate Pay third
Bank C: $8.000 – 6% Interest rate Pay first
Bank D: $1.000 – 0% Interest rate Pay last
Following the ‘snowball approach’ we would:
Bank A: $20.000 – 4.5% Interest rate Pay last
Bank B: $5.000 – 2% Interest rate Pay second
Bank C: $8.000 – 6% Interest rate Pay third
Bank D: $1.000 – 0% Interest rate Pay first
Now lets imagine that we decide to use the ‘highest interest rate approach’ but we not only owe money to banks, but also to a friend, then we would:
Bank A: $20.000 – 4.5% Interest rate Pay third
Bank B: $5.000 – 2% Interest rate Pay last
Bank C: $8.000 – 6% Interest rate Pay second
Friend: $1.000 – 0% Interest rate Pay first
It is a given that if you are in debt you need to take control over your finances, then you might be interested in:
Rich Dad Poor Dad by Robert Kiyosaki
Thanks for your time and remember, keep growing.