The American dream is to live a debt free lifestyle. Debt is a problem that plagues most individuals and households. Millions of Americans are drowning in debt due to credit card bills and delinquent accounts. Getting out of debt is a process and doesn’t happen overnight. You didn’t get into debt overnight and you will not get out of debt overnight either. It takes careful planning and a systematic approach to live the debt free dream. Today, I would like to take a look at two hugely popular strategies for getting out of debt and a third strategy that I recently came up with.
1. The Lowest Balance First Method
This method has been around for years and has been made popular recently by personal finance coach Dave Ramsey. It’s also known as the pay the smallest balance first approach. Ramsey calls it the Debt Snowball method. Debtors should pay off debts with the lowest balances first and then progress to the next smallest balance and so on.
For example, let’s say you have three credit cards with balances of $2,000, $5,000, $10,000. You would pay off the credit card balance with the $2,000 balance first and then the card with a $5,000 balance, The last credit card to be paid off would be the one with $10,000. You would only pay the minimum balances to the higher balance cards and would apply additional principal payments to the lowest balances.
The advantage of this method is that the debt payer can easily see their progress as debts are eliminated. This motivates the debt payer to keep eliminating debt and gives the payer a personal sense of accomplishment.
2. The Highest Interest Rate First Method
The most practical method for getting out of debt is paying debts with the highest interest rate first. Credit card debts with the highest annual percentage rates (APR) are attacked first. In this method the balance is not as important as the card’s interest rate.
Let’s use the preceding example again. Let’s say the card with the $2,000 balance has a 15% interest rate. The card with the $5,000 balance has a 25% interest rate and the $10,000 card has a 20% interest rate. Using the debt first approach, you would pay down the $5,000 card first, $10,000 card second, and the $2,000 card last.
The advantage of this method is that it saves the debt payer the most money. For example, paying off a credit card with a 25% APR is like getting a 25% return on your money. By getting rid of the highest interest rate first, you can potentially eliminate thousands of dollars in interest charges.
3. The Fixed Increment Method
The fixed incremental approach is a method that I developed for paying off debt. It involves setting the same equal amount of money aside to paying off each credit card debt. The key to this method is picking an amount that is at or above the minimum payment due for each debt.
Let’s assume you have cards with the same $2,000, $5,000, and $10,000 balances. You have a total of $600 per month to devote to getting out of debt. You would then send $200 per month to each card. Once the $,2000 balance is paid off, you would make $300 payments on the other two cards. This allows you to eliminate the lowest balances rapidly and takes the worry out of calculating your monthly payments. As debts are eliminated, you take the additional savings and divide it equally amongst your remaining balances.
The advantage of this method is that it is easy to follow and keeps your bill payments the same month after month.
Final Thoughts
Which method do you think works the best for eliminating debt?
Photo by: walknboston
