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The School of Hard Knocks has probably taught you one of four decision-making methods to use to pay down or pay off debt. Armed with this knowledge, you are financially prepared to lead your family or your company down a path that will be the wrong one about 75% of the time.
Debt can be good. It creates credit, allows expansion, closes gaps and funds education. Too much debt, on the contrary, can affect the family budget or the company. Once you’ve made the decision to reduce debt, this brief guide will help you determine how to best meet your goal.
In very simple terms, in order to reduce debt you must first be able to pay all minimum payments on each loan and other monthly expenses. After that, additional “debt reduction” funds must be available to implement the intent to eliminate any one debt. The extra money can be either in large chunks or in small amounts over time. The size of the money pot is less important than the process. A larger pot will help you reach your debt reduction goals faster; But a small utensil, used correctly, will still get you going in the right direction.
The question becomes: If you have multiple loans (eg… a property mortgage, vehicle loan and credit card), which do you pay off first? There are four decision-making approaches that help you identify which should be paid first: the interest rate approach, the equilibrium approach, the cash flow approach, and the risk mitigation approach.
interest rate outlook,
The demagogues of modern mythology have most likely taught you the first of the four approaches through magazines and trade journals, or on radio and television. Pay off the loan with the highest interest rate. Thus, if the mortgage’s APR is 7.4%, while the vehicle loan is 6.0% and the credit card is 5.5%, choose to pay the debt reduction funds toward the highest interest loan – the mortgage.
The logic of this approach is solid and the math is simple. It is not wrong; It’s just incomplete because it represents only one tool in your toolbox to be used when your goal is to reduce the total interest paid. And, just as a hammer is a wonderful tool, it doesn’t do much to remove a screw or cut a board in half.
balance approach,
The beauty of debt reduction is the snowball effect that allows future debt reduction payments to be much higher than starting payments. Once you’ve paid off the first loan, all else being equal, you can now add the monthly payments you were paying on that loan to your original loan reduction payment, both now on the second loan. can be applied to. The balance approach, then, guides you to pay off the loan with the smallest balance remaining on the loan when your goal is to reduce the number of loans outstanding. Thus, if the balance on the mortgage is $258,000, the vehicle loan is $3,500, and the credit card is $8,000 – pay off the vehicle loan first. This will allow you to combine the payment you were paying on the vehicle loan and your additional loan deduction payment towards the next loan – either a mortgage or a credit card.
cash flow approach,
The only consistent thing in life is “change”. Just as you should be flexible in life, you should strive to add more flexibility to your finances. The cash flow approach teaches reducing debt which will reduce monthly cash flow; Means, the amount that you will have to pay every month as the sum of all your minimum payments. Mortgage and vehicle loans are often installment loans, so even if you make a larger payment than the minimum payment this month, you still have to pay the same minimum payment next month. In contrast, credit cards, credit lines, and interest-only cards adjust their monthly payment amounts based on the loan balance. So, if the minimum monthly payment on the mortgage is $2,100, the vehicle loan is $650, and the credit card is $200 – pay toward the credit card first.
As the credit card balance is paid off, the minimum payment amount will decrease, allowing less cash to flow through your finances. This allows for the most flexibility when things take a turn for the worse, opportunities arise, or plans change.
risk reduction approach,
Lenders categorize loans based on risk appetite and so should you. Even if your plan is to eliminate all debt completely, plans change. Sometime in the future you may once again approach the lender seeking another loan, perhaps to refinance the loan at a better interest rate. Chances are good that this will happen before your total debt elimination plan is fully realized. Prepare for that possibility now by paying off higher-risk loans first to reduce your overall cumulative risk so that lenders are more likely to grant you that future loan.
Lenders first classify loans as “secured” and “unsecured”. Secured loans are backed by collateral that the lender must forego or foreclose on in order to uphold its end of the bargain. This can get complicated because lenders further classify secured loans based on the value of the collateral, how the collateral normally appreciates/depreciates, and the ability to resell it. For this reason, a well-maintained building is better collateral than undeveloped land, and both are better than a vehicle, which is, in turn, better than a boat. The better the collateral, the lower the risk associated with the loan. As you might suspect, an unsecured loan is uncollateralized. You have nothing to back it up except your word that you will pay. Therefore, unsecured loan is the riskiest loan.
Following the example above, using a risk mitigation approach – pay off the credit card first, then the vehicle loan, and then the mortgage.
best way for you,
As you can see, each approach can produce a different answer as to which debt to reduce first. Unfortunately, just like there’s no magic wand, there’s no one best way. All four approaches have great merit and can produce the “right answer”. Ultimately, it is you who must decide on a prudent financial management solution to meet your goals. Analyze using each tool. Present the results for your particular situation. Balance what you find against your personal strengths and weaknesses when weighing possible future scenarios. Then, make a decision! Any decision you make to reduce debt will not be wrong, it will only reduce the total interest you pay, reduce the number of loans outstanding, add more flexibility to your finances, or prevent you from taking out another loan. Will prepare for Whatever decision you take, take it today.
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