When you're faced with a stack of debts, it's hard to know where to start. Financial planners generally agree that the most efficient, least expensive strategy is to start with the debt with the highest interest. Get that one paid off first, then move on to the one with the next-highest rate, then the next, and the next, until you've done away with the whole pile.
The Costs of Debt
Debt is expensive. When you borrow money, you usually have to pay the lender interest for the privilege of using that money. The higher the interest rate, the more expensive that privilege becomes. Say you had $10,000 in student loan debt at an annual interest rate of 2.5 percent. That debt would cost you $250 a year. If you had $2,000 of credit card debt at 15 percent interest, that debt would cost you $300 a year. On the surface, the student loan looks like a much "bigger" debt, but the credit card debt is far more expensive -- six times as expensive on a dollar-for-dollar basis.
Ordering Your Debts
Take your debts and put them in order, from those with the highest interest rates to those with the lowest. To avoid late- or missed-payment penalties -- and the blemishes they put on your credit record -- you'll have to keep current on all of your debts. Make the minimum required payment on all of them except for the one with the highest interest. All the "extra" money you have available for debt repayment should then go to eliminating that highest-rate debt. Once it's paid, move to the debt with the next highest interest rate and repeat the process.
If the debt with the highest interest rate is a particularly large sum, it may take a while to get it paid off. For some people, that may create problems with motivation. Even though the balance on that bill is going down, they may feel like they're not getting anywhere because they still have the same number of bills coming in. If you struggle with staying motivated, you can modify your repayment scheme by starting with a relatively small debt, or alternating between focusing on debts with high rates and those with lower balances. It will end up costing you more than if you stick to the strict interest-rate order of repayment, but if it keeps you on the path to getting debt-free, it's far better than throwing up your hands and giving up.
As mentioned, just because you're devoting your energies to paying off your highest-rate debt doesn't mean you can let other bills go unpaid. You need a roof over your head, heat and electricity. If you need your car for work, you must keep making payments on your auto loan and car insurance. To find additional money to put toward paying off your debt, look to your lifestyle for areas to pare back. (Everyone needs food, but no one needs to eat out. Cable TV is not a necessity. And so on.) Write down every cent you spend; Steve Rhode of the Myvesta Foundation tells Discover Financial that doing so can help you reduce your spending 10 percent to 20 percent just by identifying needless expenses.
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