We’re back to cleaning up our finances!
Today, we’re making a plan.
We’ve figured out how much money we have and where it is going, and we’ve figured out who we owe and how much. That last one was probably a little painful, right?
Have no fear! The next part is the liberating part of financial management: make a plan to dig yourself out of the hole (if necessary) and build yourself a solid rock of money to set your family down upon!
Let’s start with our fictional family from the last post. If you remember, they were coming up with a small amount of leftover money at the end of the month after expenses were tallied.
| EXPENSES | |
| Mortgage |
1000.00 |
| Car Notes |
308.00 |
| Phones |
125.00 |
| Electric |
200.00 |
| Water |
40.00 |
| Annuals |
453.00 |
| Groceries/Gas/Misc. Living |
1457.00 |
| Student Loan |
152.00 |
| Credit Cards |
575.00 |
| TOTAL |
$4,310.00 |
|
|
|
| INCOME |
|
| Job #1 |
2900.00 |
| Job #2 |
1600.00 |
| TOTAL |
$4,500.00 |
| Difference |
$190.00 |
But they did have some debt, and they would be doing a WHOLE lot better if they didn’t have that debt hanging over their heads!
| EXPENSES | |
| Phones |
125.00 |
| Electric |
200.00 |
| Water |
40.00 |
| Annuals |
453.00 |
| Groceries/Gas/Misc. Living |
1457.00 |
| TOTAL |
$2,275.00 |
|
|
|
| INCOME |
|
| Job #1 |
2900.00 |
| Job #2 |
1600.00 |
| TOTAL |
$4,500.00 |
| Difference |
$2,225.00 |
The first step on their road to recovery is: save some money.
Sounds ridiculous, right? How can we pay off debt if we’re saving our excess money?
Well, we can’t, technically. But what we can do is start off by making sure we don’t accrue MORE debt as we journey through our plan.
If we’ve got at least $1,000 in liquid savings, then when we suddenly need new tires, or the ER copay of $250 hits, we’re not digging out a credit card to pay for the unexpected (and making our financial hole deeper)!
Step One of Paying off Debt: Save at least $1,000 in a liquid savings account.
Once we’ve achieved that goal (which for our fictional family will take a little over 5 months), then we can start paying off our actual debts.
There are a lot of thoughts and theories about this part. Financial people can sit down and tell you the exact method of paying off debt that will cost us the least amount of money, based on interest rates and payment amounts. I’ll make it simple for you, though.
The two ways to pay off debt are:
- base your payoff schedule on the interest rate of the debt, OR
- base your payoff schedule on the amount owed on the debt
If you go the “interest rate” method, you sit down and order your debts from highest interest rate charged to lowest interest rate charged. For our fictional family, it would look like this:
| DEBT |
TTL Owed |
APR |
Monthly |
| Credit Card |
22,000.00 |
22.99% |
500.00 |
| Credit Card |
4,000.00 |
12.99% |
75.00 |
| Car Loan |
16,000.00 |
6.25% |
308.00 |
| Mortgage |
118,000.00 |
4.75% |
1000.00 |
| Student Loan |
48,000.00 |
2.75% |
152.00 |
| TOTAL |
$208,000.00 |
$2,035.00 |
If you go the “amount owed” method, you sit down and order your debts similarly, but in reverse: lowest debt to highest debt. Our fictional family would have this list:
| DEBT |
TTL Owed |
APR |
Monthly |
| Credit Card |
4,000.00 |
12.99% |
75.00 |
| Car Loan |
16,000.00 |
6.25% |
308.00 |
| Credit Card |
22,000.00 |
22.99% |
500.00 |
| Student Loan |
48,000.00 |
2.75% |
152.00 |
| Mortgage |
118,000.00 |
4.75% |
1000.00 |
| TOTAL |
$208,000.00 |
$2,035.00 |
The “interest rate” method would have you start paying off your debt by first throwing every spare dime you have at the highest interest rate debt until that is completely paid off.
Our fictional family has $190 leftover after paying all their expenses. So their debt payment would change to look like this:
| DEBT |
TTL Owed |
APR |
Monthly |
| Credit Card |
22,000.00 |
22.99% |
690.00 |
| Credit Card |
4,000.00 |
12.99% |
75.00 |
| Car Loan |
16,000.00 |
6.25% |
308.00 |
| Mortgage |
118,000.00 |
4.75% |
1000.00 |
| Student Loan |
48,000.00 |
2.75% |
152.00 |
| TOTAL |
$208,000.00 |
$2,225.00 |
On that repayment schedule, it will take our fictional family over 2.5 years to pay off that first debt! (I’m keeping things very simple, and dividing the amount owed by the amount paid per month to come up with the number of months before zero balance. Interest paid over that amount of time will, of course, increase the number of months it takes to achieve zero balance.)
After they achieve that goal, they would then take the entire $690 they’d been putting towards paying that single credit card and apply it to the next debt on their list. Our fictional family now has a debt listing that looks like this:
| DEBT |
TTL Owed |
APR |
Monthly |
| Credit Card |
1,600.00 |
12.99% |
765.00 |
| Car Loan |
6,144.00 |
6.25% |
308.00 |
| Mortgage |
102,000.00 |
4.75% |
1000.00 |
| Student Loan |
43,136.00 |
2.75% |
152.00 |
| TOTAL |
$152,880.00 |
$2,225.00 |
The good news is, 2.5 years in to this plan, they’d have paid off the second debt enough with their regular $75 a month payment that it will be paid off in just 2.5 MONTHS.
And then they’d repeat the process for the next debt:
| DEBT |
TTL Owed |
APR |
Monthly |
| Car Loan |
5,528.00 |
6.25% |
1073.00 |
| Mortgage |
101,000.00 |
4.75% |
1000.00 |
| Student Loan |
42,832.00 |
2.75% |
152.00 |
| TOTAL |
$149,360.00 |
$2,225.00 |
About 6 months of that, and the car is paid off! Then they’d tackle the mortgage, then the student loan, and 5.5 years later they would owe no money to anyone for anything!
TOTAL TIME TO FREEDOM: Just under nine years.
Hey – no one said financial freedom was cheap, easy or quick! Few things in life worth having are actually any of those things.
Besides, this fictional family can pay things off faster by throwing any extra money they come across (via income tax refunds, work bonuses, gift money, or pay raises) at their debt. So it’s possible they could shave a couple years off this path to financial freedom.
Now, I’ve just gone into great detail about how to use the “interest rate” method of debt repayment, but I have a confession: I hate that method of repaying debt!
I never, ever use it.
It takes far too long to see tangible evidence of the hard work that debt repayment requires, and I’m far too impatient to wait that long for the fruits of my labor.
For me, every time I pay off a debt and no longer have to make a monthly payment, I feel a surge of accomplishment and feel encouraged to “keep up the good work” and “stay the course”.
So I use the “amount owed” method of repayment.
Fortunately, it works the exact same way! Only you start with the debt you owe the LEAST on and work your way up. For our fictional family, I’ll show you the charts for how their repayment would go.
First debt:
| DEBT |
TTL Owed |
APR |
Monthly |
| Credit Card |
4,000.00 |
12.99% |
265.00 |
| Car Loan |
16,000.00 |
6.25% |
308.00 |
| Credit Card |
22,000.00 |
22.99% |
500.00 |
| Student Loan |
48,000.00 |
2.75% |
152.00 |
| Mortgage |
118,000.00 |
4.75% |
1000.00 |
| TOTAL |
$208,000.00 |
$2,225.00 |
A little over 15 months later:
| DEBT |
TTL Owed |
APR |
Monthly |
| Car Loan |
11,380.00 |
6.25% |
573.00 |
| Credit Card |
14,500.00 |
22.99% |
500.00 |
| Student Loan |
45,720.00 |
2.75% |
152.00 |
| Mortgage |
110,500.00 |
4.75% |
1000.00 |
| TOTAL |
$182,100.00 |
$2,225.00 |
About 20 months later:
| DEBT |
TTL Owed |
APR |
Monthly |
| Credit Card |
4,500.00 |
22.99% |
1073.00 |
| Student Loan |
42,680.00 |
2.75% |
152.00 |
| Mortgage |
100,500.00 |
4.75% |
1000.00 |
| TOTAL |
$147,680.00 |
$2,225.00 |
FIVE MONTHS after that:
| DEBT |
TTL Owed |
APR |
Monthly |
| Student Loan |
41,920.00 |
2.75% |
1,225.00 |
| Mortgage |
98,000.00 |
4.75% |
1000.00 |
| TOTAL |
$147,680.00 |
$2,225.00 |
Three years later that student loan debt is gone, and three years after that, the house is paid off, too.
TOTAL TIME TO FREEDOM: almost exactly 9 years.
It might take a tad bit longer to achieve the same end results, but along the way it sure feels like you’re accomplishing more, and more quickly!
That’s enough to keep me sticking to the plan, but in the end, you have to decide which method works best for you.
Step Two of Paying Off Debt: Pick a Method and Start the Work
Again, along the way as we pay off our debt, we have to remember to throw any extra money that comes our way at it as often as we can, while keeping our $1,000 emergency fund fully funded.
But…what if we hate the idea that it will take NINE YEARS to pay off our debt?
Or worse, what if we aren’t as lucky as this fictional family and our expenses exceed our income?
Read the rest of the series:
Part One: Where Are You Standing Financially?
Part Two: Organize Your Debt
Part Four: Focus on the Details
Part Five: Design Your Dream Life
So which method do you like best? How many years will it take you to get out of debt?
Pingback: Frugal Friday – Organize Your Debt - Cradle Rocking Mama
Pingback: Frugal Fridays – Focus on the Details - Cradle Rocking Mama
Pingback: Frugal Friday - Where Are You Standing Financially? - Cradle Rocking Mama