Day#16: Make a debt repayment plan.

Posted by on Dec 5, 2009 in 25 Days to Healthier Finances, Debt | 0 comments

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.

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