You’ve already built a proper emergency fund and are taking advantage of your employer’s match if they offer one. Now what? Well, if you want to make any further progress with your financial life then you’ll need to rid yourself of any high interest rate debt. There’s no point in investing any further money to make a 7% return in the market when your credit cards are costing you 16% or your student loans are at 9%.
What’s considered high interest rate debt?
High interest rate debt is any money that you owe with an interest rate that’s ~4% higher than the 10-year US Treasury. So, as of this article, the 10-year US Treasury is at 2.08%. That means that any debt with an interest rate of (2.1% + 4%) 6% or higher is considered high interest.
Next, you’ll want to put together a list of every high interest rate debt you owe with the following fields:
- Debt Name
- Debt Amount
- Interest Rate
- Minimum Payment
- Payoff Date/Period
Below, is an example of various forms of high interest rate debt that you may have. Try to generate a list like this for yourself that you keep up-to-date every month.
In what order should I pay them off?
There are two common recommendations for paying off your debt. What they both have in common is to always pay the minimum amount owed each month first. So, I’d recommend you setup automatic monthly payments to each of your debt accounts for the minimum amount to avoid late fees. After completing this, you’ll have to decide what strategy to use to pay them off quicker.
Method A (Snowball) is to pay off the smallest debt amount first. In the example above, you’d pay any extra money you have to Student Loan A since it’s the smallest amount at $4,000. Once payed off, you’ll start on the Personal Loan at $8,000. This method has been recommended from a morale and ease-of-management standpoint because you can quickly start paying off the number of debts owed. This will snowball quickly in the beginning and make you feel like you’re paying off your debt fast because you have a lower number of debt accounts. Although this strategy has been recommended frequently, it’s not the fastest way to payoff your debt. And, if you want to increase your morale, in my opinion, knowing I’m using the quickest debt payoff method (Method B) does the trick in and of itself.
Method B (Avalanche). The quickest method. Pay any extra money you have to the debt account with the highest interest rate. In the example above, you’d start with the Credit Card Debt at 16%. Once payed off, you’ll start on Student Loan B at 9.5%. This method is the quickest because you’ll accrue less interest over time, and your payoff date will be sooner than method B.
Does the method matter?
If you’re unsure how Method B is better/quicker than Method A, let’s run the numbers. The example below uses the numbers from the chart above. It assumes you’re paying the minimum amount on each account every month plus as extra $300 using Method A (Snowball) or B (Avalanche).
As you can see from the chart above, method B will save you $2,310 and get you out of debt two months quicker. This is why I recommend method B. It’s the best mathematical approach. But, if method A works for you, it’s still better than only paying the minimum on each loan which would cost you an extra $7,000 in interest. And, the real goal is to just get out of debt because the interest adds up fast.
If you have high interest rate debt, put together a list of all debts owed. Then create a plan to pay them off. Setup automatic payments so the process is thoughtless. It can be a long process to get out of debt but with a plan, you can see where the finish line is and have a strategy to get there faster. And once you’re there and free of high interest rate debt, your options for financial growth really open up! Stay tuned for upcoming articles on investing once you’ve completed steps 1-3 of the process.
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