Describe a good strategy for reducing your debt or paying off your loans.

Question

What will be an ideal response?

Answer 1

Begin by listing all of your debts. You have to know everything you owe. Then establish an emergency fund. Having an emergency fund before beginning debt payoff will prevent setbacks. Arrange all of your debts in order. Determine in what order you want to pay off your debts based on your payoff strategy. Pay off the first debt first. Tackle the first debt with everything you can while only paying the minimum on the others. Once the first loan is paid off, use the money from the first debt to add to the payment on the second debt. Now you start tackling the next debt on the list with everything, including the money from the first debt. Once the second debt is paid off, focus on the third loan with the money from the first and second loans. Continue until you are debt free. Many financial experts advocate to pay off the loan with the highest interest rate first. List your debts in order of highest to lowest interest rate. Begin by paying off your highest-rate debt first, since that is costing you the most in interest. Then work your way down to the last debt. This may make the most sense for you but is not right for everyone. Mathematically this approach makes sense, but personal finances are more about the person than the math. What if your highest—interest rate loan is one of your largest and will take five years to pay off? Are you willing to adjust your lifestyle and work towards paying off your first debt if it will take that long to check even one debt off your list? One of these other two methods may make more sense. Begin by paying off your smallest debt first and then moving on to the next smallest until you eventually get to your largest. Add every extra dollar you can to the payment of your smallest loan. This approach leads to quicker gratification as you quickly check the first loan off your list. The success of paying off your first debt gives you the emotional charge to continue to work towards the next debt. It also quickly gives you a much larger payment to work on the second debt. By starting with the smallest debt first you pay off the easiest loan first. By the time you get to your last debt you will be making a very large payment. Focusing on the smallest debt first is a very powerful and quick way to eliminate debt. And the more you add to your debt payments, the faster you eliminate your debt. If you like to check items off your list quickly this method may be for you. A second way to approach paying off your debt is to create cash flow first. Concentrating on monthly cash flow is also a good way to decide which debt to go after first. It is particularly effective if you are running into cash flow problems (running out of money) each month and need to free up some money. In this case focus on the debt that will free up the most money in the shortest time yet is still reasonable for you to do. The decision of which debt to tackle first is a little more difficult, as this is a judgment call based on your own set of circumstances. A third approach is to determine which of your debts has the highest payment but can still be paid off in a reasonable amount of time given the amount of extra money you can add to the payment. This is easily determined by using your time value of money calculator, plugging in the larger payment amount, and solving for number of time periods (N). Just as with the other methods, once the first debt is paid off turn your focus on the second. Unlike the other methods, if you are using this approach to increase your cash flow, you will probably use the money you are no longer paying on the first loan and spread that out to your other budget categories.