The School of Hard Knocks has likely taught you one of the four decision-making approaches used to pay down or pay off debt. Armed with this knowledge, you are ready to fiscally lead your household or your company down a path which will only be wrong about 75 % of the time.
Debt can be good. It builds credit, allows expansion, closes gaps, and funds education. Too much debt, conversely, can plague a family budget or a company. Once you have made the decision to reduce debt, this short guide will assist you in determining how to best accomplish your goal.
In very simple terms, to reduce debt you must first be able to pay all of the minimum payments on each debt and other monthly expenses. After that, additional “debt reduction” funds must be available to apply to one of the debts with the intention of eliminating it. Additional funds can either be in a large lump or in smaller sums over time. The size of the pot of money is less important than the process. A larger pot will help you reach your debt reduction goals faster; but, a smaller pot, used correctly, will still take you in the proper direction.
The question becomes: If you have multiple debts (say… a property mortgage, vehicle loan, and credit card), which do you pay off first? There are four decision-making approaches that help you identify which should be paid first: Interest Rate Approach, Balance Approach, Cash Flow Approach, and Risk Reduction Approach.
Interest Rate Approach:
Demagogues of modern mythology have, most likely, taught you the first of the four approaches through magazines & trade journals or on the radio & television. Pay down the debt with the highest interest rate. Thus, if the mortgage has an APR of 7.4% while the vehicle loan is 6.0% and the credit card is 5.5%, choose to pay debt reduction funds toward the highest interest loan – the mortgage.
The reasoning of this approach is sound and the math is simple. It is not wrong; it is just incomplete as it represents only one tool in your toolbox to be used when your goal is to reduce 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.
The beauty of debt reduction is the snowball effect which allows future debt reduction payments to be much larger than starting payments. Once you pay off the first debt, all else being equal, you can now add the monthly payment you were paying on that debt to your original debt reduction payment, both of which can now be applied to the second debt. The Balance Approach, then, guides you to pay down the debt with the smallest balance left on the loan when your goal is to reduce the number of debts owed. Thus, if the balance on the mortgage is $258,000, the vehicle loan is $3,500, and the credit card is $8,000 – pay off the vehicle loan first. This will allow you to combine the payment you were paying on the vehicle loan plus your additional debt reduction payment toward the next debt – either the mortgage or the credit card.
Cash Flow Approach:
The only consistent thing in life is “change.” Just as you must be flexible in life, you must strive to add greater flexibility to your finances. The Cash Flow Approach teaches to reduce the loan that will reduce monthly cash flow; meaning, the amount that you must pay each month as the sum of all your minimum payments. Mortgages and vehicle loans are often installment loans, so even if you make a large payment above the minimum this month, you will still owe the same minimum payment next month. On the contrary, credit cards, credit lines, and interest only loans adjust their monthly payment amounts based on the balance due. So, if the minimum monthly payment on the mortgage is $2,100, the vehicle loan is $650, and the credit card is $200 – pay toward the credit card first.
As the credit card balance is paid down, the minimum payment amount will go down causing less cash to flow out of your finances. This allows the most flexibility should things turn for the worse, opportunities arise, or plans change.
Risk Reduction Approach:
Lenders categorize debt based on risk exposure and so should you. Even though your plan may be to totally eliminate all debt, plans change. Sometime in the future you may once again find yourself before a lender seeking another loan, maybe to refinance a loan at a better interest rate. Chances are good this will happen before your total debt elimination plan is fully realized. Prepare now for that likelihood by paying off high risk debt first to reduce your overall cumulative risk so lenders are more likely to grant you that future loan.
Lenders first categorize debt as “secured” and “unsecured.” Secured debt is backed by collateral that the lender can repossess or foreclose upon should you cease to keep up your end of the bargain. This can be complicated as lenders further categorize secured debt based on the value of the collateral, how the collateral normally appreciates/depreciates, and the ability to resell it. For this reason, a well-maintained building is better collateral than undeveloped land, and both are better than a vehicle which, in turn, is better than a boat. The better the collateral, the less risk associated with the debt. As you might suspect, unsecured debt is uncollateralized. It has nothing to back it up except your word that you will repay. Unsecured debt is, therefore, the most risky debt.
Following through with the above example, using the Risk Reduction Approach – pay off the credit card first, followed by the vehicle loan, and then the mortgage.
The Best Approach for You:
As you can see, each approach can produce a different answer as to which debt to reduce first. Unfortunately, just as there are no magic wands, there is not a best approach. All four approaches have great merit and can produce the “right answer.” In the end, it is you who must decide the prudent financial management solution to meet your goals. Run through the analysis using each tool. Lay out the results for your particular situation. Balance what you find against your personal strengths and weaknesses while weighing in possible future scenarios. Then, make a decision! No decision you make to reduce debt will be wrong, it will just minimize your total interest paid, reduced the number of debts owed, add greater flexibility to your finances, or prepare you to seek another loan. Whatever decision you make, make it today.