Day#16: Make a debt repayment plan.

This is Day #16 of “25 Days to Healthier Finances”, a series of blog posts where Frugal Pinoy readers and myself work on 1 task a day to make our financial lives better. Please stay tuned for the next installment of this series, which will be up tomorrow. Here’s today’s installment:

If you performed the task for Day 11 (computing your net worth), you already know how much your debt is. Now it’s time to try and eliminate it. Of course, those without any debt can skip this task.

Today’s Task: Make a debt repayment plan.

You’ll need some pen and paper, a calculator, and any paperwork referring to your debt (credit card statements, loan agreements, etc.) If you’re using a budget, it may come in handy too.

The thing about repaying debt is that there are many different ways to do it. There’s no such thing as “The Solution”, there’s only what works for you. Here are some common methods you should think about:

The Highest-Interest Method

1. Make a list of all your debt including credit cards, mortgages, and other kinds of loans. Remember to include personal loans such as money lent to you by relatives or friends.
2. For every item on that list, write down the following: remaining repayment balance, current interest rate, and the minimum monthly payment.
3. Spot the debt with the highest interest rate, then rank the rest of your debt accordingly. (The one with the second-highest rate is #2, the third-highest rate is #3, and so on.)
   
4. Any extra money you save or earn each month should be channeled to repaying the debt with the highest interest first until it is fully paid. Keep paying your minimum payments to your other debts, but the extra cash should go to the one with the highest interest debt until you’ve eliminated it from your list.
   
5. Repeat as needed until you’ve repaid all your debts.
   

The benefit of this approach is that it tends to be faster. If you have the discipline to do this, you won’t accumulate more debt via large interest rates.

The Debt Snowball Method

This method, popularized by Dave Ramsey, is a more psychological approach to debt repayment. Instead of paying off the loan with the highest interest rate first, you start with the one with the smallest balance. By crossing out one debt from your list, you’ll get an emotional boost and hopefully become more inspired to get out of debt. Here are the steps to do it:

1. List all your debt in ascending order, with the smallest balance first.
2. Each month, commit to pay the minimum payment on all your debts while channeling extra saved/earned money to the debt with the lowest balance.
3. Once you’ve paid off the first debt, the money that used to go to that debt (at least the minimum payment) should now go to repaying the debt with the second smallest balance.
4. Repeat until you’ve repaid all your debts.

Usually, if your debt with the smallest balance isn’t the one with the highest interest, it may take you longer (and a bit more money) to pay it back. The math just doesn’t side with the debt snowball method. But if you know yourself well enough to know that you’ll need the inspirational boost to cross off one debt from your list, then this is the approach to take.

Variations of the Above Methods

You can do a combination of both of the above methods, of course. One way to do it is to “snowball” your first complete repayment – pay the one with the lowest balance first. Once you’ve repaid that, maybe you can pay the rest of your debts according to their interest rates. Whatever happens, you must make the minimum payment for each debt each month. Otherwise, you’ll usually incur more interest and additional fees.

If you’ve gotten out of debt (or stayed out of it to begin with, like I have), please share your story with other Frugal Pinoy readers by submitting a comment.

Getting Out of Debt vs. Saving: Which should you prioritize?

I received this question from Frugal Pinoy reader “vodkacoke” in my email inbox last week:

I really like your style of writing and the topics tackled in your site. Thanks for reinforcing financial literacy to Filipino community. I believe we really need that.

Anyway, my question is do you need to clear all debts first before you start saving or can you do both together?

Since the email address he/she left with me was invalid, I thought it would be good to discuss my answer here. Also, this is an issue I haven’t discussed in the blog yet.

Back to vodkacoke’s question:

Do you need to clear all debts before you start saving, or can you do both together?

It’s complicated to answer this question, as it depends on many things:

• how much savings you already have (if any),
• how much interest you’re paying on your debt,
• the amount you owe,
• how much you can save each month, and
• how secure you are with your source/s of income.

People who aren’t worried about financial emergencies or losing their source of income can benefit from paying off the debt with the highest interest rate first and focus on that until it’s completely paid off. Also, if your debt is also something you can pay off within 1 or 2 months, then there’s no reason for you to put off eliminating it. The point is that you should carefully plan your debt repayments. Here are some handy articles on debt-elimination by other bloggers:

• The Snowball Method
• The Snowflake Method 
• Comparing Debts and Developing a Debt Repayment Plan

Although debt payment should be a financial priority, this doesn’t mean you should neglect to save up for emergencies. Saving is especially important to those who don’t have an emergency fund to cover unexpected expenses. If it’s possible, do both at the same time. Slowly pay off your debt while setting aside some money for your emergency fund.

Whatever method you choose, the important thing is to to avoid incurring additional debt along the way. Getting into more debt, no matter how small, delays your ability to set aside money for your savings. This is why having even at least a small amount of savings is essential, even if you still have debts to pay.

If I were in this position, I’d put my money both in debt repayments and my emergency fund until my emergency fund reaches P10,000. After that, I’d throw all my money into debt repayments until I’m out of debt. I’ll also look for additional income sources so that I can set aside more money each month for debt repayment. Once I’m debt-free, I’ll put my extra money into padding that emergency fund to up to 6 months’ worth of living expenses.

Why P10,000? Well, that depends on your lifestyle, but for me P10,000 is enough for regular emergencies such as medical expenses, auto repairs,urgent home repairs, etc. While it’s true that you won’t be earning much interest on the emergency fund, it’s still better to have at least some cash for emergencies so that you do not resort to incurring more debt.

There’s no cookie-cutter answer for everyone. The balance between debt payments and savings is something you have to figure out for yourself given the conditions listed above.

How about you? What advice would you give vodkacoke and the others out there who are trying to balance debt with savings?

If you’d like to ask a question like vodkacoke did, or send in a guest article for this blog, please click here to contact me.

Photo Credit: Image by Woodsy