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Personal Finances / Credit Cards and Consumer Debt
|Subject: SpeleoFool's Rules - Debt Priority||Date: 11/4/1999 2:42 PM|
|Author: SpeleoFool||Number: 19189 of 308881|
Let's apply some of what we've learned. If you haven't been following my Rules messages, now is a good time to play catch-up. It all started with an Introduction (post#18962). Next, I wrote about the power of Interest Rates (post#18966). Then I discussed the importance of maximizing your Net Worth (post#19025). Now I want to show you how this knowledge can help you to Get Out Of Debt!
Most everyone here will agree that before you start to get out of debt, you need to address the habits that put you there. Before you do anything else you must resolve to stop adding new debt. Period. From this day forward, if you can't get it with cash you have in hand, you can't have it. Second, you must take inventory of your situation. Determine all of your debts and all sources of income. Third, you must organize this information into a budget. In other words, you need to build a plan of attack against your debts. That's where this post comes in.
If you're ready to plan your attack then read on. If not, I'd suggest browsing the Credit Card and LBYM boards for more advice about how to get started. There's plenty of golden advice and helpful Fools out there to assist you.
The Snowball Attack
One of the things you should have in your budget is a minimum amount that you pay each month to reduce your debt. Say this is $500. That means that you dole out that $500, sometimes more but never less, among your debts each and every month. Eventually this will get you out of debt. But you are Foolish. You don't just want to get out of debt; you want to fight that debt in the smartest possible way. The basic way to do this is through a "snowball" type plan.
The idea is simple. You apply the minimum payment to each of your debts, then take whatever is left over and throw all of it against a single debt. Let's call this your Most-Hated Debt (MHD). You are, in effect, paying down your MHD as fast as you possibly can. When that is paid off you will have all of your extra money from before plus the minimum payment from your MHD available to throw at a new debt. You then pick a new MHD and repeat the process.
So, how do you pick your MHD? I'll evaluate several common methods* below, then tell you the "right" answer. :)
* Disclaimer--I made up my own neat-sounding names for these methods
The Tiny-Balance Approach
Using this method, your MHD is whichever debt has the smallest balance. The advantage of the Tiny-Balance Approach is that it is the quickest way to free up minimum-payment money to apply to other debts. On the surface, this sounds like a very Foolish way to go, but it's not the fastest or cheapest way to get out of debt. However, that doesn't mean you should dismiss this approach. If, for example, you find that your available cash is less than your required minimum payments, then you might want to consider taking a temporary second job and using the Tiny-Balance Approach to free up some much-needed cash. You might just be able to perform the financial equivalent of flying your X-wing out of the Death Star as it explodes.
The Cash-Builder Method
This method involves creating an index for each debt by dividing the balance by the monthly payment. For example, if you have an $8000 debt that requires a $200 payment, your index is 40. The debt with the smallest index is your MHD.
An equivalent way of looking at this is to divide the payment by the balance, then pick the largest result. What you are calculating is your payment as a percentage of your debt. What you are picking is the debt with the largest minimum payment per dollar of debt. The effect you'll see is that you free up as much money as possible with the lowest possible total payments. In other words, this method is the most efficient means to free up minimum-payment money. However, it's still not the fastest way to get out of debt.
The Foolish Interest-Crushing Method
This is the fastest way out of debt. It's beautifully simple--your MHD is the one with the highest interest rate. The reason that this method is so powerful is because it minimizes how fast your debt grows larger while you're busy paying it off. Over time, more of your payment goes toward principal, thus reducing interest even further. You're putting the power of compounding interest to work for you by preventing interest from compounding against you. Confusing, I know.
It helps to consider things one dollar at a time. Suppose you have several debts. Debt A is at 12% interest and Debt B is at 24%. In a single month, Debt A will grow by 1% and Debt B will grow by 2%. Put another way, if Debt A was $1 it would become $1.01; Debt B would become $1.02. If we had just one dollar to spend, which debt should we have paid? Why, Debt B of course! We save a penny that way. Easy, huh? It's no different when Debts A and B are many dollar balances of different amounts and we have many dollars to spend. Each dollar that goes toward B saves a penny vs. putting it toward A. And old Ben Franklin was right: a penny saved is a penny earned.
Getting Out of Debt
So, there you have it. I've at least contractually met one of the promises in my Introduction: I've described how to create a Get-Out-Of-Debt plan. Just stop building debt, make a budget, and attack your highest interest debt first. But like the Fool I am, I'm not quite ready to call it quits. There are a lot of differences between the World of Math and Real Life. We must take into account things like taxes and annual percentage yields (APYs) to know what our highest interest rates really are. We must also plan for emergencies, irregular expenses and a little bit of fun. Finally, we need to understand our own tolerance level for risk. All of these topics and more will be coming soon to SpeleoFool's Rules.
Until next time, Fool On!
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