Debt is a four-letter word we all have to face. Any time we spend more than we make we’re probably making up the difference by going into debt. It’s a common problem, but it’s something many of us know very little about. If you find yourself in debt you need to know the right way to pay it off, which involves an easy three step process you can follow no matter how severe your debt.
Step 1: Get Organized
The first step is to get organized by making a list of all your debts. Your list should include the lender, outstanding balance, term of the loan, interest rate and monthly payment for each debt you have. Search through online statements and old mail to help you remember all of your debts, including home loans, vehicle loans and other personal debt.
Here are some of the debts you may have:
Home loans: 1st mortgage, 2nd mortgage, equity line, equity loans
Vehicle loans: car and boat loans
Other personal debt: credit cards, personal loans, education loans, taxes owed
Step 2: Rank Your Debt
Once you’ve identified your debts, your next step is to rank them according to their interest rates from highest to lowest. If you don’t know the interest rate on a particular debt make sure you ask your lender. Knowing your interest rates is the most important piece of information for this exercise because the order you rank your debt becomes the order you should pay them off.
Step 3: Start Paying It Off
The third step is to start paying off your debts based on their rank, with the highest interest rate debt being paid off first. Regardless of the balance you owe, you should always follow this method and pay off your highest interest debt first after you’ve satisfied all of your minimum payments.
As a general rule, you want to pay off your debt more aggressively anytime the interest rate you’re being charged exceeds the return you’re receiving on your investments. In today’s market, the average return on investments is below zero, but assume the average long term return is between 6 and 8%. This means that any debt you have with an interest rate greater than 6% should be paid off as soon as possible. This may mean getting a second job or dipping into your emergency savings to stop the interest from accruing.