In earlier articles, I have shown you how creating an Emergency Fund and developing an entrepreneur mindset can give you the much-needed mental boost on your journey to financial freedom. An emergency fund gives some backup to life’s little hiccups. An entrepreneur mindset makes sure that you remain in the right frame of mind to succeed.
So now that you have a little cash set aside and the willpower to keep moving toward financial freedom, let’s take a look at the best debt reduction strategies to wipe out your debts.
Spend less or earn more
We have already spoken about the formula for achieving financial freedom; spend less than you earn. Now, my philosophy is that the best way to do this is to earn more money rather than having to budget and live a frugal lifestyle. But, some of you may have a different take on life and may be willing to live on less.
Either way, to cut your debts, you need more money to help pay them off as quickly as possible. Only then can you start saving and investing your way towards financial freedom. Here are 3 strategies which I would like to present to you:
- Pay off your highest interest rate debt first
- Pay off your smallest debts first
- Pay of your debts with the highest emotional baggage first
Let’s look at the pros and cons of each of them individually.
1. Pay off high interest rate debt first
With this method of debt reduction, you need to list all your debts from the highest interest rate to the lowest interest rate. You then start paying the minimum amount on each of your debts and contributing as much as you can afford to the debt with the highest interest rate.
After you have paid off your highest interest rate debt, take that payment and add it to the payments you were making on the debt with the next highest interest rate. Continue to make minimum payments on the remaining debts. Rinse and repeat until all your debt has been paid off.
By using this method of debt reduction, you pay off your debts with the highest interest rates first, so this method will save you the most in interest payments. This means that you will pay off your debts in the shortest time.
However, if your high interest rate debt is large, it will take longer to pay off the individual debts and this may discourage people from continuing with the strategy.
2. Pay off the smallest debts first
Another approach to reducing your debt is to list your debts from the smallest to the largest balances. Then, use the strategy as above and pay the minimum amount on each debt and contribute as much as you can afford to your smallest balance. After your first debt is paid off, take that payment and add it to the payments you are making on your second debt. Again, rinse and repeat until you are debt-free.
This method of debt reduction is good if you are the type of person who likes to see their individual debts being paid off sooner. It can be emotionally fulfilling to see the number of debts reducing.
The downside of this method is that debts with high interest rates won’t be paid off until later. This means you will pay higher interest rates for longer and, therefore, your total debt will take longer to pay off. Maybe you want to think about a combination of these two approaches!
3. Pay off your emotional debts first
This strategy for debt reduction is a little more radical than the last two methods. With this method, debts are listed in the order of their emotional impact on you. For example, you may want to pay back a family member who gave you an interest-free loan because of the emotional baggage attached to the loan. Or pay back a friend who lent you money when you “left your wallet at home”!
The strength of this method is that it allows you to reduce the psychological stress caused by borrowing money from people close to you. By removing these debts first, you will feel motivated to continue paying down your remaining debts.
By not paying down the highest interest rate debts first, this method also means paying more interest and taking longer to pay off your debts than using the previous strategies. Also, allowing your emotions to rule your debt strategies is probably what got you into this mess in the first place!
How do these debt reduction strategies stack up?
Here are the results of running the following example through a spreadsheet that is available here.
- $8,000 student loan, 5.00% interest, $85 minimum payment
- $2,000 credit card, 25.00% interest, $70 minimum payment
- $25,000 credit card, 17.00% interest, $620 minimum payment
- $5,000 auto loan, 5.00% interest, $95 minimum repayment
- $3,000 loan from family, 0.00% interest, no minimum repayment
The total minimum monthly repayments would be $870.
Now, let’s assume we can contribute $1,000 per month to use towards debt reduction.
- If we use the strategy of paying off the highest interest rate debt first, the total debt would be repaid in 55 months and the total interest paid would be $11,767.
- If we use the strategy of paying off the smallest debts first, the total debt would be repaid in 58 months and the total interest paid would be $14,299.
- If we are emotionally attached to the loan from the family and then paid off the remaining debt starting with the highest interest rate, the total debt would be repaid in 58 months and the total interest paid would be $14,260.
You can see that the most cost-effective way to pay off your debt is to pay off the highest interest rate loans first. By using this strategy in the example above, the total savings in interest payments is around $2,500. The total debt would also be paid off 3 months earlier, allowing you to divert your monthly repayments (which you no longer have!) into your savings and investments.
By using a debt reduction strategy and increasing your earnings through a side hustle (which will allow above monthly minimum repayments), you can become debt-free. It will take commitment and may be emotionally challenging, but you can do it.
So, make the decision now. Challenge yourself to become debt-free as quickly as you can.
How long will it take? Only you and your new-found mindset know the answer.
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