Debt Repayment Strategies

Mark Cuban said, “Pay off your debt first. Freedom from debt is worth more than any amount you can earn.” I must admit that I agree with him – especially in regard to consumer debt! Your greatest wealth building asset is your income, so it’s important to have it fully at your disposal and not eaten up by a multitude of payments.  If you’re coming toward the same conclusion, here are four different ways to tackle debt repayment.

Debt Snowball

This approach is all about the quick win and gaining traction.  You list your debts in the order of least outstanding balance to greatest outstanding balance.  Then you make minimum payments on all of them except the smallest one at the top of the list. This is the debt that you have targeted, and with your sights locked, you apply every spare cent you can to pay it off as quickly as possible. For a lot of people, that first debt will be wiped out in a month or two because it’s a low balance that’s just hanging out and cluttering your budget with a small payment. Once it’s gone, tackle the next smallest debt adding to its minimum payment all the extra cash you now have available from paying off the first debt. Then you rinse and repeat through each of your debts, watching the payments you make become more and more mammoth as each debt is zeroed out. This approach is best for people just getting started with personal finance and who are eager to experience some financial wins.

Debt Avalanche

This approach is for the mathematician in all of us who really despises paying interest.  Rather than organizing your debts based on outstanding balance, you list your debts in the order of highest interest rate to lowest interest rate regardless of amount owed. Like the debt snowball, you target the debt at the top of the list and attack it with everything you can. Once it’s paid off, roll that payment into the minimum payment of the debt with the next highest interest rate, continuing until all are gone.  This approach is best for people who already have a firm commitment to get rid of debt and want to conserve as much of their money as possible. It’s especially good when your debts are all comparable in size. 

Cash Flow

This approach is for the person who needs to free up monthly cash for a recurring expense that’s coming – for example student loans coming out of deferment. List your debts based on the size of your minimum payments due.  Order them from largest minimum payment to smallest minimum payment.  Apply your extra cash against the debt that will free up the cash flow you need. Once it’s gone, focus on another debt that will give you the additional cash flow you seek by paying it off. This is a great way to handle debt repayment if you really need some breathing room in their budget. 

Emotional Improvement

List your debts in the order of emotional strain they give you. For example, you owe money on a car that you’ve never owned but were a co-signer for. That payment infuriates you every time you make the transfer or draft the check. This negative emotion is no good for your psyche or stress levels, so target the debts in order of greatest emotional baggage.  Like the other approaches above, apply all your extra money toward your targeted debt while you pay minimums on all others. When it’s paid off, do a dance and update your budget to target the next debt. This approach is ideal for somebody who is desperately seeking emotional peace. 

For me personally, I always recommend clients to begin with the debt snowball to eradicate small debts first.  This gives you relative quick wins and momentum. The speed of those initial payoffs is tremendously gratifying, and truly gives you the right headspace needed to tackle the larger debts.

Once the smaller debts are gone, I recommend reviewing the debt repayment strategies to decide if there is a clear gain from re-prioritizing the larger debts based on interest, cash flow, or emotions. For example, one client chose to attack her car payment ahead of a credit card. She owed about $500 more on her car but it had a $350 minimum payment whereas the credit card minimum payment was $170.  By attacking the car loan with every spare cent, she is able to pay off the car in 6 months staging her budget to more easily include a known future expense that will come into effect early next year. 

Most importantly though, if you take nothing else away from this article, remember that you are best served by choosing one debt to focus on. No matter which approach you take, focus is necessary for your success! Choose one debt and attack it with everything you have while paying minimums on all the others. When it comes to debt repayment, “divide and conquer” is no approach to take.