The School of Hard Knocks has likely taught you one of the four decision-making approaches used to pay off or settle debt. Armed with this knowledge, you’re 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 plague a family budget or business. Once you’ve made the decision to reduce debt, this brief 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 intent of eliminating it. The additional funds may be in a large amount or in smaller amounts over time. The size of the money pot is less important than the process. A larger pot will help you reach your debt reduction goals faster; but, a smaller pot, used correctly, will still get you going in the right direction.
The question is: If you have multiple debts (for example, 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 should be paid first: interest rate approach, balance approach, cash flow approach, and risk reduction approach.
Interest rate approach:
The first of the four approaches was most likely taught to you by the demagogues of modern mythology through trade magazines and newspapers or on radio and television. Pay off the debt with the highest interest rate. So, if the mortgage has an APR of 7.4% while the car loan is 6.0% and the credit card is 5.5%, choose to pay debt reduction funds toward the loan. with the highest interest: the mortgage.
The reasoning behind this approach is sound and the math is simple. Not bad; it is simply incomplete, as it represents just one tool in your toolbox to use 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 larger than the initial payments. Once you pay off the first debt, all things being equal, you can now add the monthly payment you were paying on that debt to your original debt reduction payment, both of 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 car 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 your next debt, whether it’s your mortgage or credit card.
Cash flow approach:
The only consistent thing in life is “change”. Just as you should be flexible in life, you should strive to add more flexibility to your finances. The cash flow approach teaches how to reduce the loan that 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 car loans are often installment loans, so even if you make a large payment over the minimum this month, you’ll still owe the same minimum payment next month. By contrast, credit cards, lines of credit, and interest-only loans adjust your monthly payment amounts based on the balance due. So if the minimum monthly mortgage payment is $2,100, the car loan is $650, and the credit card is $200; pay the credit card first.
As the credit card balance is paid off, the minimum payment amount will decrease, causing less cash to flow from your finances. This allows for the greatest flexibility in case things take a turn for the worse, opportunities arise, or plans change.
Risk reduction approach:
Lenders classify debt based on risk exposure, and so should you. Even if your plan is to completely eliminate all debt, plans change. At some point in the future, you may find yourself again with 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 probability now by paying off subprime debt first to lower your overall cumulative risk so lenders are more likely to make that future loan.
Lenders first classify debt as “secured” and “unsecured.” Secured debt is backed by collateral that the lender can repossess or foreclose if you fail to meet your end of the bargain. This can be tricky 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 undeveloped land, and both are better than a vehicle which, in turn, is better than a boat. The better the collateral, the lower the risk associated with the debt. As you might suspect, unsecured debt is unsecured. You have nothing to back it up except your word that you will pay. Unsecured debt is therefore the riskiest debt.
Continuing with the example above, using the de-risking approach: Pay off the credit card first, then the car loan, then the mortgage.
The best approach for you:
As you can see, each approach may produce a different answer as to which debt to reduce first. Unfortunately, just as there are no magic wands, there is also no best approach. All four approaches have great merit and can produce the “correct answer”. In the end, it is up to you to decide on the prudent financial management solution to meet your goals. Perform the analysis with each tool. Tailor the results for your particular situation. Balance what you find against your personal strengths and weaknesses as you weigh possible future scenarios. So, make a decision! No decision you make to reduce debt will be wrong, it will only minimize your total interest paid, reduce the amount of debt owed, add more flexibility to your finances, or prepare you to look for another loan. Whatever decision you make, make it today.