Determining the Best Debt Repayment Plan for You

The top question I hear as a personal finance educator and credit counselor is, “What’s the best way to pay off my debt?” This isn’t surprising. Debt is a massive financial migraine that can make daily life pretty miserable, and shining a lot of light on the problem can often make us feel nauseated.

I’ve heard and read lots of answers to this question. Shouldn’t this have a simple response? Actually, there are plenty who want to complicate it. I’m not one of them. Here’s my simple answer:

Most of us should start by organizing our debts from the lowest balance to the highest balance and send extra payments to the debt on the top of the list while making minimum payments to the rest.

That’s it! If you’re okay with that, feel free to check out a number of different personal finance topics that we cover on the site.

Lowest Balance Approach

Okay, if you’re still reading, you either want to know why, or you are among a portion of the population who feels like ripping the financial lungs out of anyone who adheres to such heresy that counters the wisdom of focusing instead on the account with the highest interest rate first. Rest assured, there is no need for that.

I am quite aware that the debt repayment method that makes the most financial sense is to send extra payments to our debt with the highest interest rate first. That seems like a no-brainer, but here’s the thing: this is the accountant’s method. It’s meant for the financially disciplined who are self-motivated to pay off all of their debts. The problem is that most of us (though certainly not all) who got into a lot of debt didn’t accomplish that feat through disciplined and self-motivated efforts.

Instead, here’s what I suggest for the majority of those wanting to pay off their debts: focus on paying off the smallest balance first. Whether your debt comes from the undisciplined use of credit, from not having an emergency savings fund at the time of a job loss, or from mile-to-moderate medical, vehicular, appliance or other should be expecting (but weren’t quite ready for) living expenses, this is the best method for most of us to start with.

Here’s my rationale behind this heresy. By focusing any extra payments that you can make on the debt with the lowest balance first, you’re most likely to get rid of your first creditor sooner than with the highest APR method. Also, each time you pay off a debt, it’s one less monkey on your back and one more reason to stay motivated to repay all of your debt.

It’s all about motivation. Use this “lowest balance method” to get started. Then, once you find your motivation to keep going, I think it would be a great idea to switch to the “highest interest rate method” from there on out.

Highest APR Approach

Whether from the start or after paying off one or two accounts using the lowest balance approach, switching to the highest APR approach can make a lot of financial sense.

However, if you were to focus on the highest APR from the beginning, it could take a year or more to pay off your first account, and all the while you’re making minimum payments to some department store card with a $300 dollar balance that just keeps hanging around, even though you’re making the requested monthly payment. A year later, thanks to the power of compound interest and the slippery slope of minimum payments, you’re still making payments to the highest APR debt, and the department store card with a 19% APR still has two more monthly payments required before it’s paid off. That’s enough to dishearten anyone who feels trapped in an endless cycle of consumer debt.

So, yes, if you are – or once you become – the disciplined type, I wholeheartedly believe in sending extra payments to the debt with the highest interest rate. Most of us, though, will need to focus the extra payment on the debt with the lowest balance early on.

Other Methods

There are other methods I’ve read about for paying down debts that include everything from considering payment-to-balance ratios to cashing out a 401(k), taking out a home equity loan, negotiating with creditors, and more. I’m not going to say that these methods don’t work, because I know they can and do for some people.

Here is my warning to anyone considering some of these methods:

First, avoid anything that sounds or feels too complicated. It might work, but if you’re not totally sold on it or don’t completely understand it, you’re probably setting yourself up for a financial downfall.

Second, don’t drain cash from your emergency savings or from a retirement account to pay off credit cards and personal debts. At some point in the near future, you will probably need some cash (think appliance replacement, vehicle repair, back-to-school shopping, etc.), and if you’ve drained your savings account, you’ll be tempted to put such purchases all on a credit card and end up right back where you started. If you borrow from your 401(k), you’re putting your financial future at risk. 401(k)s are protected, to a large extent, even when filing for personal bankruptcy. Plus, I love how a student in one of my classes summed it up: “You can borrow money for just about any emergency, but not for retirement.”

Third, borrowing money against the equity in your home is dangerous on multiple levels. To begin with, you’re essentially using an asset that has real value in it and draining its value in order to pay for “unsecured” debt. Credit cards, collections, and many other types of debt are unsecured, which means there wasn’t anything put up as collateral for the loan. Essentially, the creditor cannot come into your home and take anything if you default on the loan.

The two main types of “secured” debts are home loans and vehicle loans (many RV, boat, and motorcycle loans are also secured debts). The danger of using a home equity loan is that you’re paying off unsecured debt with additional secured debt against the home. The worst of it though, is that 70 to 80 percent of households who use a home equity loan to pay off credit card debt will, within just a couple of years, run credit balances right back up to their previous levels. So now they have credit card debt and a home equity loan that puts their home ownership at risk. Like borrowing against a 401(k) or draining a savings account, this option does not address the real problems many with credit card debt face: poor money management or insufficient emergency funds.

Negotiating with Your Creditor

I would suggest considering calling the creditor up front. I don’t typically suggest negotiating a settlement on the principal balance owed. However, it certainly can’t hurt to ask creditors to lower their interest rates. They may refuse. It’s up to the individual creditor and, to the same extent as with other customer service issues in life, up to their phone representatives on what they can or will do for us. Having a history of on-time payments to that creditor, along with asking nicely, will certainly help. Threatening to transfer your balance to another credit card is also a tried-and-true way of extracting additional concessions from the credit card company.

Collections

However, if you’re not dealing with credit card companies but rather collection agencies, you’re likely to get pretty much nowhere with your requests. They have purchased your account from your previous creditor (for much less than what is actually owed on the account), so they now possess the same rights as did the previous creditor. However, they typically want their money, they want their profit, and they want them both now.

My two suggestions for dealing with collection accounts are:

1. As soon as you get the collection notice, call the previous creditor and ask if they can bring your account “back in-house,” so that you can set up monthly payment arrangements with them.

2. Consider offering less than the full balance owed to the collection agency.

The collection agency paid considerably less for the account than what was owed, so often anything above 20 or 30 percent of the balance will be profits in their pockets. However, be aware that such negotiations will quite possibly result in more damage to your credit. Unless you get it in writing that they will not resell the amount they’re forgiving, you could look forward to being contacted down the road by yet another collection agency that purchases the “forgiven” amount from the previous collection agency. Insist on getting any such agreement in writing.

Conclusion

When all is said and done, the best approach to paying off your debts is the one that best matches your personality and your situation. Some consumers may use the lowest balance approach as a young adult but feel the highest APR approach is their best option when dealing with consumer debts in their 40s or 50s.

The reality is that any of these approaches is better than no approach at all. So skip the FOMO, and start accelerating your debt repayment today. Choose an approach and get started today. Your future self will thank you for it.