One of the greatest barriers to individuals saving money and reaching financial goals is debt1. Many households struggle with high debt levels from housing, credit cards, automobiles, and student loans. Having excessive debts can make it difficult to work towards other important goals such as saving and investing. Often when individuals are overly burdened it may feel impossible to create a plan that can assist with debt elimination. We want to emphasize two strategies that can help to speed up the process of getting out of debt. The first thing that should be done is all consumer debts (all debts but the house), should be separated. Below is a list of debts that we will use as an example:
- Car loan of $8,000 (3% interest rate) with a $420 monthly payment
- Credit card debt of $11,000 (18% interest rate) with a $200 monthly payment
- Student loan of $17,000 (6% interest rate) with a $250 monthly payment
Both strategies to eliminate this debt involve making minimum payments for each loan, and then focusing everything extra on just one of the loans to pay it off more quickly. The difference in strategy is based on which loan is prioritized to pay off first.
The first method is to focus on whichever loan is smallest. In this case, the car loan is the smallest loan. The borrower would continue to make the minimum payments for the credit card, car loan and the student loan. All extra money each month would be applied only to the car loan. The idea is that by focusing on the smallest loan first it will be paid off more quickly. Once the car loan is paid off the borrower would only have the credit card and student loan and would then be able to put all extra money each month (including the amount that went to the car loan before it was paid off) towards the credit card since it would be the next smallest loan.
The second method is to focus on whichever loan has the highest interest rate. In this case, the credit card has the highest interest rate at 18%. The borrower would continue to make the minimum payments for the credit card, car loan and the student loan. All extra money each month would be applied only to the credit card. The idea is that by focusing on the loan with the highest interest rate it may help minimize the total amount that is paid in interest. Once the credit card is paid off the borrower would only have the car loan and student loan and would then be able to put all extra money each month (including the amount that went to the credit card before it was paid off) towards the student loan since it would be the next highest interest rate.
Both of these methods are commonly used in the process of eliminating consumer debt and the method chosen is less important than the fact that individuals get started so they can begin the process.
1 Elkins, Kathleen, “Here’s the No. 1 reason why Americans are struggling to save money – and it’s not debt”, CNBC, NBCUniversal New Group, 15 March 2019, https://www.cnbc.com/2019/03/15/the-no-1-reason-why-americans-struggle-to-save-money-isnt-debt.html