Monday, 22 October 2012

Paying Off Debt - Different Methods

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In previous posts, I've covered much about changing your spending patterns and negotiating with creditors. This post is simply about differing ways of paying off your debts, whether you're in trouble or not, and the benefits of doing it using these methods.

You might automatically think that it's always best to pay as much off the debt with the highest interest rate first, because it accumulates fastest, however that isn't always the case.

There's often more than the interest rate to consider

For instance, a loan with a much larger balance but lower interest rate, can potentially cost you more in interest each month, so it would make more sense to pay the one with the higher interest off first, rather than the one with the higher interest rate.

Here's the first method, called the Debt Snowball, which despite it's name, is quite a good one.

Imagine you have 4 loans and you have £100 pound a month spare to pay them with. Let's say the payments and loan amounts happen to be as follows:
Loan 1  £1,000   £25/mth
Loan 2    £500    £25/mth
Loan 3  £2,000   £40/mth
Loan 4    £500    £10/mth
After long enough Loan 2 clears first. When this happens, instead of sitting back and feeling pleased with yourself, you take the £25/mth you were paying towards Loan 2 and spread that evenly over the other 3 repayments. You are still paying out £100/mth on your loans, but you are now paying those other 3 at a slightly faster rate. And this is where it gets it's name from. As you go on, there is a snowball effect. Each loan gets paid off quicker when one of the others is finished with.

This makes especially good sense with credit cards, as when a credit card balance reduces, the minimum payment asked for by the card company reduces too, and it's very tempting to cut how much you pay off that card every month. You should try and ignore this because it's precisely how credit cards make their money.
I was given an example once where if you pay the minimum payment on a well known credit card with a balance of £3,000 at a typical interest rate, it would take decades to pay off and you would repay 5 times the original debt in interest alone.
This method can also be combined with some other methods to good effect, or looked at from a psychological point of view. Yes, I'm going to waffle on about psychology yet again, but it's something that needs thinking about, as not all of us have iron grips on ourselves 100% of the time.

Putting more cash towards smaller loans initially means they will pay off more quickly, and as they are small, that should happen in a relatively shorter time. When a loan is paid off, we feel we've actually achieved something, and it gives us encouragement to stick at it with the bigger balances.

Alternatively, some people prefer to see the balance of their bigger debts come down more quickly, caring less about smaller debts they see as less important or less of a worry. They put much larger amounts towards the bigger balances, meaning they see these reduce faster and it makes them feel better about it, hence they are better able to stick to their plan.

I know someone who has stuck to this latter method for years, and although he still has credit card debt, he's paid his mortgage off completely, and I have to say, I feel a little bit jealous about that. He says he feels great, because he actually owns his home outright now, and whatever happens, should he lose his job or whatever, he'll always have the roof over his head regardless.

Another method used by people to chip away at their debt, is making payments every 4 weeks. It means they have to budget slightly differently, but it means they end up making 13 payments on everything each year, instead of 12. It works, because although some months you might find yourself making 2 payments, if you set it up right, you won't be doubling up on everything in the same month, and it doesn't feel that much less affordable than 12 monthly payments.

All these different methods have one thing in common. They are all designed to help you stick at it. It is far, far easier to spend money and run up debts quickly, than it is to pay them off again. Paying off debt usually requires a decent level of commitment over a protracted time period, and it's because of the length of time that people often lose interest and crack.  Each method above plays on a slightly different attitude or psychology to make things feel easier and less of a mountain to climb.

As the ancient Greeks said - "Know Thyself". The secret to putting, and keeping your personal finances in order, is to find a way of dealing with them in such a manner that over time you become more keen to keep to your plan, and not less.

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