I have written several times in this column about the creation of an emergency fund. In my mind, setting up an emergency fund that will cover 4-6 months of expenses should be your # 1 financial priority.
But what if you’ve already done it? What should your financial goal be now?
I recommend that you pay off your debt. And I know some of you are frustrated because you want to get out of debt, and know you have to get out of it, but you just don’t know how to do it.
The first step to getting out of debt is to find the extra money in your budget. Then you add those dollars to your payments. If you only pay the minimum on all of your bills, it will likely take you years (maybe decades) to get out of debt and pay a small fortune in interest.
So find a few extra dollars in your budget each month by working a few extra hours, eating less in restaurants, or spending less on entertainment, for example.
Next, you need to choose a âdeleveragingâ strategy.
Two of the most popular methods of paying off debt are Debt Snowball and Debt Avalanche.
Both strategies involve paying more than the minimum monthly payment.
Say you owe $ 20,000 for student loans (4.5% interest rate), $ 8,000 for credit card # 1 (19%), $ 4,000 for credit card # 2 (16%) and $ 7,000 for your car (5.5%).
The minimum payment for each is as follows: student loans $ 300; credit card # 1,150; credit card # 2,100; car loan $ 175.
If you used the Debt Snowball method, you would organize your debts from smallest balance to largest and pay them in that order. If you were to use the debt avalanche method, you would order your debts according to the interest rate and pay off the debts with the highest interest rates first.
After reviewing your budget, you find that you have $ 100 more each month to pay extra on your debt.
Using the numbers from our example situation above, if you used the Debt Snowball method, you would target credit card # 2 first because it has the smallest balance. You would apply your extra $ 100 each month to that debt and pay the minimum amount on every other bill.
When you get credit card # 2 paid off, you take the $ 200 you paid each month and pay that extra amount each month on the next biggest debt, which is the car loan. You would now pay $ 375 per month for the car.
When you pay off the car, you take the $ 375 you paid on the car loan and apply it to the No. 1 credit card bill. Now you are paying $ 525 each month for this bill.
You keep doing this until you have paid off all of your debts.
The biggest advantage of using the Debt Snowball method is that since you are targeting the smallest debt first, you should be able to pay it off relatively quickly. You get a quick win which builds your confidence. And that motivates you to chase after other debt.
Some people criticize the Debt Snowball method because they say you should attack the debt with the highest cost or interest rate first. Mathematically speaking, they are right.
In the example above, credit cards have the highest interest rate by far. Hence, you would save more money by paying them off first.
If you can be disciplined in paying off your debt and don’t need the quick wins that Debt Snowball brings, you might prefer the Debt Avalanche strategy.
Using the Avalanche Method, you would organize your debts according to interest rates, starting with the highest rates.
So you need to pay credit card # 1 first. Just like in the Snowball method, you would apply the payment you send to credit card # 1 to credit card # 2. You continue this model until you’ve paid off all of your debt.
So, should you use Debt Snowball or Debt Avalanche to pay off your debt?
At the end of the day, it’s really up to you. Both strategies work.
The important thing is that you choose one of the methods and start paying off your debt today. It might not be easy, it probably won’t be particularly fun, but you can do it.
When you get rid of your debt and the stress that comes with it, you’ll be glad you did.
Dave Kinzer is a music teacher and financial coach in Springfield. Contact him at www.davekinzer.com. His column will appear here every other Wednesday.