Today we’re going to talk about that horrible four letter word: DEBT.
It can feel like it’s crushing you. It can feel like you can’t get out from under it. Thankfully, if you feel like that, there are several approaches you can take not only to tackle your debt, but to save hundreds, if not thousands of dollars along the way.
Good Debt vs. Bad Debt
The first thing you need to know is whether you have good debt or bad debt. Simply put, good debt is any debt that puts money in your pocket.
I’ll give you an example. If you have $1000 mortgage on a rental property and you collect $1500 in rent from the tenant each month, you’re going to keep most of that $500 difference. Of course, there’s a few run costs needed to maintain a property, but you will get to keep most of that $500, putting money into your pocket.
That’s good debt, and you don’t need to pay it off unless you have a specific goal or aspiration to do so. Good debt is one of the most common tools used by the wealthy to continue to aggregate more wealth.
In contrast, bad debt is any debt that takes money out of your pocket. For example, with credit card payments you owe payments toward it every month, so it continually takes money out of your pocket. It drains you financially.
If you have bad debt, you will want to pay if off as quickly and efficiently as possible.
How to Pay Off Debt, Effectively
Given this context, if you have bad debt, how can you pay it off quickly and save yourself a ton of money in the process? The answer is that there are four tactical approaches to employ when it comes to smart debt paydown.
All of them are incredibly effective, but which one you choose will depend on your unique situation. Read on to learn more.
1. Pay Off Your Highest Interest Debt First
The first approach is to pay off your highest interest debt first. The reason to do this is that it will save you the most in interest payments over time.
For example, interest rates right now on home mortgages tend to range from 4 to 7%, but credit card interest rate can go up to 25% or even higher. Meaning, you could easily owe an interest rate of 20%, 22%, or 25% on your credit card.
In this case, you’d definitely want to tackle your highest interest rate debt first. This would save you the most money over time.
2. Pay Off Your Lowest Debt Amount First
Approach number two is to pay off your lowest debt amount first. Meaning, if you had a $500 debt, a $1000 debt, and a $5000 debt, with this approach, you would pay off your smallest $500 debt first.
To do this, you would make the minimum payments on your higher amount debts, while aggressively paying off your lowest amount debt. Then, as soon as your smallest debt is paid off, the amount you were used to paying toward it would be put toward paying down your second smallest debt.
Once your second smallest debt is paid off, you would roll that payment amount toward your third smallest debt. Meaning, you would be taking the amounts that you had previously paid toward your smaller debts and would be applying them toward your next largest debt, until you have paid off all of your debts.
For obvious reasons, this approach is often called the “Snowball Method.”
Basically, it attacks the smallest debt amount first, and once it is paid off you start rolling the amount you’re used to paying for it toward the other debts that you’re paying down.
The main benefit of this approach is that it is emotionally satisfying, and humans are not robots, we are emotional creatures. It can feel really satisfying to close down a loan account because it has been paid in full.
Thus, people who use this approach tend to stick with it and become debt free faster.
3. Pay Off Your Highest Credit Utilization Loan First
The third approach is one that most people miss. But, it’s really important if you have a financial goal, such as buying a house or getting a larger loan in the future. If you plan to do anything that requires a good credit score, then this approach is one you will want to consider.
With this approach, you pay off your highest credit utilization debt first. Put simply, credit utilization is the amount of debt you’re using divided by the amount of debt that you have available to you.
For example, if you have a $5000 limit on a credit card (the amount of credit available to you) and you owe $4,900 on it, that represents a 98% credit utilization ratio. Here’s the math: $4,900 / 5,000 = 98%.
Unfortunately, having a line of credit with such a high credit utilization ratio is going to slam your credit. It’s going to tank it.
Anytime you’re over 30% credit utilization on a line of credit, it will hurt your credit score. And naturally, the lower your credit utilization ratio, the better. If you can get it down into the single digits, that is ideal.
Thus, if you’re looking to get a mortgage or a larger loan in the future, you may want to pay down your debt with the highest credit utilization ratio first.
4. Pay Off Debts that Don’t Provide Tax Advantages First
People also tend to forget about this fourth and final approach, but it’s critical to consider because it has quantifiable monetary value to you in the form of IRS tax breaks.
With this approach, you take note of which of your debts have tax deductible interest and and which ones do not.
I’ll give you a few examples. In most cases, the mortgage interest paid on a home owned in the U.S. is tax deductible. Student loan interest is also deductible in most cases (up to $2500 per year).
In contrast, the interest paid on other types of loans—such as credit cards and auto loans— is not tax deductible.
Thus, you can often save money by paying off your non-tax deductible loans more aggressively, while making minimum payments toward your tax advantaged loans.
Getting Strategic About How You Pay Down Your Debt
To summarize, there are four approaches to paying off debt that can be smart and effective. Understandably, the approach you choose will depend on your individual situation.
The first approach is to pay off your highest interest debt first. The second approach is to pay off your lowest debt amount first. The third approach is to pay off your highest credit utilization debt first. The fourth approach is to pay off your non-tax advantaged debt first, while making minimum payments toward your tax advantaged debt.
I hope these approaches are helpful. I hope they save you a ton of money on your path toward financial freedom. Let me know which approach you’re going to implement in the comments. Good luck!