I answered a post today on a financial forum in response to a question about which debt the poster should pay off first. Since I handle this sort of thing with my clients every day, I thought I might also share my recommendations with you, my readers.
Getting out of debt takes a commitment, but more than that it takes having a plan. Part of that debt free plan should include what debts you have and in what order you are going to pay them off. Most people think paying just a little bit more than the minimum payment to each debt is the best strategy. While that works, it will also keep you in debt a lot longer than you need to. I doubt that is the desire of very many people.
So what order should you pay you debt? Actually it’s not that hard. You see the key to getting out of debt quickly is to free up positive cash flow and then apply that cash flow to paying down debt. Your goal should be to pay down the one debt that will free up the most cash flow the fastest. In other words which debt will get me the most positive cash flow bang for my buck.
To figure this out, try the following exercise:
- Write each of your debts down the left side of a piece of paper.
- Make three columns to the right of your debts.
- In the first column write down the outstanding balance on each of your debts.
- In the second column write down the monthly payment.
- Divide the monthly payment of each debt by its outstanding balance (ie outstanding balance = $10,000, Monthly payment $500…$10,000/$500 = 0.05)
- You will get a number with a decimal point, now move the decimal to the right two spaces and write this number down in column three (0.05 = 5.00)
- Do this with each of your debts, the debt with the highest number in column three is the debt you should focus on paying down first.
- Once the first debt is paid off, take the increased cash flow you now have and apply it to the second highest number in column 3, and so on down the line.
If you apply this technique (the same technique I use to coach my clients) you will start to see your debts melt away. It might be slow at first, but once that first debt is paid off, and then the second, you will see the rest of your debt wiped out very quickly.
Lastly, notice I said nothing about interest rate.* Why, because I don’t care. When it comes to quick debt elimination, cash flow is king.
*Interest rate is only important if it is at 0%. Unless you are in a serious cash flow crunch, there is no need to pay off a 0% debt early since it isn’t costing you anything.