You don’t have any high-interest debt (any interest rate over 10%). If you do have high-interest debt, you have a plan to pay it off as quickly as possible.
Why it Matters
High-interest debt (any debt with more than 10% interest*) is very expensive. All that interest could be getting you closer to your Big Ambition instead of going to the lender. You want to look at paying high-interest debt down as quickly as possible so that instead of paying interest, you can further your financial well-being by saving for emergencies and your other long-term goals.
Goals for this Level
In Level 3 we want to make sure two things are in place:
You know if you have any high-interest debt
You have a plan to pay it off as quickly as possible
1 - You know if you have any high-interest debt
We need to start by knowing what you’re working with. Write down every single debt you own, no matter how big or small. Include the creditor (who you owe), the amount owed, minimum payment, and the interest rate.
Creditor | Amount Owed | Monthly Minimum Payment | Interest Rate |
e.g EZ-Spend Credit Card | $1,000 | $20 | 19% |
2 - You have a plan to pay it off
Now we need to know how much money you have available each month to chip away at your debt.
Revisit the budget you created in Level 2. How much are you currently putting towards wants and savings? How much could you redirect to paying off your debt more quickly? We need a big round number to work with. For example, let’s pretend you had $500 to put towards debt each month.
Next, we need to pick a strategy. When trying to aggressively pay down debt, our goal is to make the minimum monthly payment on all debts but pay a little extra on one debt at a time. Making the minimum monthly payment will start to minimize damage to your credit score, and paying a little extra on the debt will help extinguish the debt more quickly.
For example, imagine you had three debts and $500 to put towards debt each month. In the first month, you pay the minimum balance on the first two credit cards, and use the remaining money all against the final card, just like the chart below:
| Amount Owed | Minimum Payment | Month 1 Payment | New Balance |
EZ Spend Credit Card | $1,000 | $10 | $10 | $990 |
Even Ezier Spend Credit Card | $1,200 | $10 | $10 | $1,190 |
Eziest Spend Credit Card | $480 | $10 | $480 | $0 - paid in full |
| | Total Amount Paid Off: | $500 | |
In our example, now that you have fully paid off the Eziest Spend Credit Card is paid off, the next month you would make the minimum payment on the first debt, and put the remaining $490 towards the second debt:
| Amount Owed | Minimum Payment | Month 2 Payment | New Balance |
EZ Spend Credit Card | $990 | $10 | $10 | $980 |
Even Ezier Spend Credit Card | $1,190 | $10 | $490 | $700 |
Eziest Spend Credit Card | $0 | $0 | $0 | $0 - paid in full |
| | Total Amount Paid Off: | $500 | |
But how did we know which credit card to pay off first? There are two widely accepted methods to prioritizing your debt:
1: Pay the smallest debt first (also known as the Snowball Method)
In this method, you focus on paying the smallest debt off first so that you experience early wins in your debt repayment plan, build positive momentum, and are energized to stick with it as you tackle your bigger debts. Your success snowballs as you move from paying off small debts to paying off larger ones.
This method often works best for people because you have a sense of accomplishment more frequently than tackling larger debts. The drawback is that this may cost you more money in the long term because the debt with the smallest balance may not necessarily have the highest interest rate. Higher interest rate = your paying more in interest.
2: Pay the highest interest rate debt first (also known as the Avalanche Method)*
In this method, you focus on paying off the debt with the highest interest rate first, so that over time you are paying less interest, and your monthly debt repayment money can pay off more of your debt at a time. The higher your interest rate, the more you are actually paying your lenders while you are still in debt, which is why the Avalanche Method will save you more money over the long term vs. the Snowball Method.
The problem with the Avalanche Method is that you may not get the immediate sense of satisfaction from tackling your smaller debts, and it can be difficult to stay motivated.
Research published by Harvard Business Review suggests that the Snowball Method is more effective for most folks, noting “people are more motivated to get out of debt not only by concentrating on one account but also by beginning with the smallest.”
After you’ve picked your approach, you need to go back to your debt inventory and reorder the debts in the order you want to pay them off.
Debt Priority # | Creditor | Amount Owed | Monthly Minimum Payment | Interest Rate |
1 | | | | |
2 | | | | |
3 | | | | |
4 | | | | |
Looking to supercharge your debt payoff?
Call each lender and ask if you can qualify for a lower interest rate
Consider if a balance transfer credit card may help you pay off debt more quickly. MoneySense.ca has a great article at this link.
Does your debt feel unmanageable? GetSmarterAboutMoney.ca (run by the Ontario Securities Commission) has a detailed article on options available to you.
*Untangle Take
At Untangle Money we believe that high-interest debt starts at around 5%. The reason for this is: in order to take into account the volatility of investments, we want you to have a buffer in the risk you're taking. At Untangle we like this buffer to be 2%. That means, in order to prioritize debt that you're paying 5% on, your alternative would be making a 7% (5% rate that you're paying on your debt + 2% buffer to account for volatility) rate-of-return on your investments. This corresponds to a portfolio made up entirely of an S&P 500 index. Your personal buffer may be lower or higher than our 2%.
We also like the Snowflake Method, which is putting down small random amounts onto your debt at any time, and frequently (think a couple of times a week) to accelerate the payoff. Remember, Snowballs and Avalanches are all made up of small snowflakes, and it can be really gratifying to see the amounts going down. (Just make sure that you don't pay a fee for these transfers).
While from a math perspective we like the Avalanche method the best, we aren't going to go against behavioral science. Pick the method that resonates most with you and get rid of that debt!
A neat way of making debt-repayment feel tangible is to buy post-it notes. Find a place to put them on the wall. Put one post-it for every month you have remaining to pay off your debt. When you make the debt repayment, rip that post-it off the wall, and throw it in the garbage.
What's next?
Stay tuned every Thursday for a new level in the series!
In case you missed it:
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