Debt reduction plans

by Sean on March 11, 2006

Let’s see…debt reduction plans. I’ve heard this bandied about before, and I’ve heard the answers given before. Each debt reduction guru has their own debt reduction plan, but obviously only one of them can be “the best” plan for debt reduction. I mean, it makes sense – each person’s debt is as simple as the interaction between the amount they borrowed, the terms of their loan, and how much and how often they’ve made payments in the past. It’s reduceable to a mathematic formula.

So, if one person has a specific loan, then there’s a debt reduction method that will work best for them. Similarly, if a different person has the same loan, obviously the same debt reduction method will work best for them, right? As it turns out, the answer is, “No.” See, if we were all robots without preferences or habits, we could all use the same method for debt reduction. Unfortunately, what may seem to be a straightforward answer, mathematically speaking, is not at all straightforward when you take into account personal differences.

If you have no trouble following a plan to the letter, and motivation is not a problem, then you can simply arrange your debts in order of highest to lowest interest rate, regardless of the remaining balance. Pay the minimum payment on each of them, and if you have any money left over put it towards the debt with the highest interest rate. Once that first debt is paid off, take the money that went to paying it off, including any extra, and put it towards the debt with the next-highest interest rate. Continue this pattern until all debts are paid off.

There you have it: the mathematically-proven best way to pay off debt. Simple, right? Not if you’re the kind that needs motivation. If that’s the case, you might want to try Mary Hunt’s Rapid Debt Repayment Plan, which will allow you to see some of your debt (the smallest ones) being paid off rapidly. Believe me, this kind of motivation is really important to some people.

The Rapid Debt Repayment Plan, or RDRP, requires that you take on no new debt, which makes sense. With the RDRP, you’ll arrange your debts in order of lowest-to-highest “duration until payoff”, which is the balance plus interest, divided by the monthly payment. Again, you’ll make minimum payments on each debt, focusing any extra money on the first debt on your list. As each is paid off, concentrate your efforts on the next debt, and so on until you’re debt-free.

The next-most-effective debt reduction plan is the Debt Snowball method popularized by Dave Ramsey. This debt reduction plan requires you to:

1) List all of your debts in ascending order, from smallest balance to largest.
2) Pay the minimum payment on every debt.
3) Find a little extra money to apply towards the smallest debt.
4) Pay the minimum payment plus the little extra amount towards the smallest debt until it’s completely paid off.
5) After the first debt is paid off, add the minimum payment from the first debt and the extra amount, and apply the total to the second smallest debt.
6) Repeat this process until all debts are totally paid.

The Debt Snowball method of debt reduction is slightly less effective than the Rapid Debt Repayment Plan in terms of minimizing interest, but only slightly.

As far as other debt reduction plans go, there’s probably tons of them. But what it all boils down to is, “Do you want to pay off your debts as fast as possible, or do you want to take the easier way out and pay them off more slowly?” If it’s the first option that you want, use the “mathematically-best” option that I described first. If it’s the second option you want, use either the Rapid Debt Repayment plan or the Debt Snowball debt reduction plan. That’s it, question answered.

Anyway, thanks for the first post, Michelle. I hope you enjoy the free personal finance book that I sent. As a reminder to all you out there, if you don’t already have a personal finance blog, you’re welcome to contribute to this one, and you’ll get a cool bonus, too.