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Angles one tool in your toolbox to be used when your goal is to reduce total interest paid. And, just as a hammer is a wonderful tool, it doesn’t help much to remove a screw or cut a board in half. Balance Approach
Four Approaches to Paying Down Debt By Christian D. Malesic, MBA, IOM your debt reduction goals faster; but, a he School of Hard Knocks has smaller pot, used correctly, will still take likely taught you one of the four you in the proper direction. decision-making approaches used to pay down or pay off debt. Armed with The question becomes: If you have this knowledge, you are ready to fiscally multiple debts (say...a property mortgage, lead your household or your company vehicle loan, and credit card), which do down a path which will only be wrong you pay off first? There are four decisionabout 75 % of the time. making approaches that help you identify which should be paid first: Interest Rate Debt can be good. It builds credit, Approach, Balance Approach, Cash Flow allows expansion, closes gaps, and funds Approach, and Risk Reduction Approach. education. Too much debt, conversely, can plague a family budget or a company. Interest Rate Approach Once you have made the decision to reduce debt, this short guide will Demagogues of modern mythology have, assist you in determining how to best most likely, taught you the first of the four accomplish your goal. approaches through magazines and trade
In very simple terms, to reduce debt you must first be able to pay all of the minimum payments on each debt and other monthly expenses. After that, additional “debt reduction” funds must be available to apply to one of the debts with the intention of eliminating it. Additional funds can either be in a large lump or in smaller sums over time. The size of the pot of money is less important than the process. A larger pot will help you reach 24
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journals or on the radio and television. Pay down the debt with the highest interest rate. Thus, if the mortgage has an APR of 7.4% while the vehicle loan is 6.0% and the credit card is 5.5%, choose to pay debt reduction funds toward the highest interest loan–the mortgage. The reasoning of this approach is sound and the math is simple. It is not wrong; it is just incomplete as it represents only
The beauty of debt reduction is the snowball effect which allows future debt reduction payments to be much larger than starting payments. Once you pay off the first debt, all else being equal, you can now add the monthly payment you were paying on that debt to your original debt reduction payment, both of which can now be applied to the second debt. The Balance Approach, then, guides you to pay down the debt with the smallest balance left on the loan when your goal is to reduce the number of debts owed. 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 plus your additional debt reduction payment toward the next debt– either the mortgage or the credit card. Cash Flow Approach The only consistent thing in life is “change.” Just as you must be flexible in life, you must strive to add greater flexibility to your finances. The Cash Flow Approach teaches to reduce the loan that will reduce monthly cash flow; meaning, the amount that you must pay each month as the sum of all your minimum payments. Mortgages and vehicle loans are often installment loans, so even if you make a large payment above the minimum this month, you will still owe the same minimum payment next month. On the contrary, credit cards, credit lines, and interest only loans adjust their monthly payment amounts based on the balance due. 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 down, the minimum payment amount will go down causing less cash to flow out of your finances. This allows the most flexibility should things turn for the worse, opportunities arise, or plans change.