1) Create a Personal Balance Sheet: The purpose of a personal balance sheet is to show you your financial picture at a specific point in time. In a previous post I show how to create a personal balance sheet which is basically just a list of your assets (everything you own i.e. cash, stocks, bonds, house, etc…) and liabilities (everything you owe, credit card debt, auto loans, home mortgage, etc…). By creating a balance sheet you will create a complete list of all debt you have. Continuing from my balance sheet example in the previous post, here is example of “debts” (liabilities).
2) Identify Your Most Expensive Debts: The next step is to list your debt in order of the most expensive to the least expensive. Your credit card debt and personal loans will likely be the most expensive debt you have with interest rates well over 10% per annum. If you need a little more information on credit card debt, check out this article here by Credit Counseling Society.
3) Calculate Your Average Cost of Debt: After you have listed all of your debt and the annual interest rates you can calculate your average cost of debt. To do so simply determine the percentage of each debt relative to your total debt balance. Then multiple this percentage by the interest rate for each debt and sum them. The total is your average cost of debt in terms of an average interest rate. The spreadsheet below may help you if you are not clear on this point.
4) Reduce Your Average Cost of Debt: The next step is to reduce your average cost of debt by decreasing interest rates by as much as possible for each of the debts on your list. Clearly, it makes sense to focus on your high balance, high interest rate debts. In this case, the student loans and mortgages have the highest balances but have relatively low interest rates at 4.5% and 3% respectively and the credit card has the highest interest rate at 13%. Therefore it makes the most sense to focus on reducing the rate of higher interest rate debt such the credit card debt and also look into refinancing your mortgage. Consider applying for a new credit card with a lower interest rate on balance transfer and purchases.
If I assume a reduced introductory interest rate of 0% on balance transfer and purchases by moving the balance to a new credit card and re-financed the mortgage at a rate of 4.25%, then the average debt cost would decline to 4.23%. An average debt cost reduction of .28% might not sound like much, but over years the savings on a total debt balance of $241,500 would amount to thousands of dollars.
5) Create a Debt Payment “Snowball”: The final step is creating a simple plan to pay down all of your debts as quickly as possible. The approach I like to use is what may be referred to as a “debt payment snowball”, meaning that as you pay down each of your debts you continue to build the size of your payment applied to the remaining debt. For example, below is the first 6 months of a “debt payment snowball” where we assume an extra $500 is applied for monthly debt payments. We also assume the minimum monthly payments are made on the other debts and mortgage payments. For simplicity, we are assuming these are principal payments only.
You will notice that after month 2, the $1,000 credit card balance is paid down completely. However, we do not decrease the extra $500 debt payments, we simply now apply the $500 to the next debt, which is the line of credit. Since that is a smaller balance with only $400 remaining it is paid off in full in month 3 and the remaining monies are applied to the auto loan. By months 4, 5 & 6 and so on we are paying a chunky amount of $600 to the car loan even though the monthly payment is only $50. If we continue to apply this approach to the last debt on our list we will reduce debt quicker by creating a “snowballing” monthly payment.