Pay the debt
The Hard Knock School has likely taught you one of the four decision-making approaches used to pay off or pay off debt. Armed with this knowledge, you are ready to fiscally steer 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, by contrast, can plague a family or business budget. 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 should be available to apply to one of the debts with the intent to eliminate it. The additional funds can be in a large amount or in smaller amounts over time. The size of the pot of money is less important than the process. A bigger pot will help you reach your debt reduction goals faster; but, a smaller pot, used correctly, will still lead you in the right direction.
The question is: if you have multiple debts (for example, a property mortgage, a car loan, and a credit card), which one do you pay first? There are four decision-making approaches that help you identify which should be paid off first: interest rate approach, balance approach, cash flow approach, and risk reduction approach.
interest rate approach:
You have most likely been taught the first of the four approaches 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 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 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, 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 remaining 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 car loan first. This will allow you to combine the payment you were paying on the car loan plus your additional debt reduction payment for the next debt, whether it is the mortgage or the credit card.
cash flow approach:
The only consistent thing in life is “change.” Just as you need to be flexible in life, you should strive to add more flexibility to your finances. The cash flow approach teaches 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 auto 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 owed. 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 out of your finances. This allows for the most flexibility should things take a turn for the worse, opportunities arise, or plans change.
Risk reduction approach:
Lenders rate 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 again find yourself facing 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 reduce your overall cumulative risk so that lenders are more likely to make that loan in the future.
Lenders first classify debt as “secured” and “unsecured.” Secured debt is backed by collateral that the lender can recover or foreclose on if you default on your end of the bargain. This can be tricky as secured debt is further classified by lenders 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 may 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 risk reduction 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 is no magic bullet, there is also no best approach. All four approaches have great merit and can produce the “right answer.” In the end, it is up to you to decide 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 up your mind! No decision you make to reduce debt will be wrong, it will only minimize your total interest paid, reduce the amount of debt you owe, add more flexibility to your finances, or prepare you to look for another loan. Whatever decision you make, make it today.