When people are trying to dig themselves out of a debt hole, there are three top questions they typically ask.
Here’s what they wonder:
- Should I consolidate my debt?
- Should I still save when I’m trying to pay off my debt?
- Should I pay off the debt with the highest interest rates first?
Should I Consolidate My Debt?
Paying off your debt isn’t just about following a formula. You need to be strategic and serious. So let’s start with the first question: Should I consolidate my debt?
Sure, the ads sound enticing: Pool all your debt and have one convenient loan payment and possibly lower monthly payments. And for some this might be a good deal. But generally, I don’t recommend debt consolidation. For one thing, it gives people the impression that they’ve paid off some debt.
But actually, when you consolidate, you haven’t paid off any debt. You generally haven’t addressed the reason you’re in debt in the first place. You’ve just shifted the debt — and sometimes that shifting results in your stretching the debt out longer and paying even more interest.
Additionally, when people wipe debt off their credit cards for example, pushing the debt into a consolidation loan frees up the cards. And guess what often happens?
Yup, you guessed it: They then go back and charge up the cards often because they don’t have any savings. An emergency expense comes up and they use their credit card to bail themselves out.
Don’t pool the debt. Keep every payment. I want you to suffer to pay it off. Because if you painstakingly cut expenses or get another job to pay down the debt, my hope is you will remember the stress and not get into that situation again.
Should I Still Save When I’m Trying to Pay Off My Debt?
Next, folks who become serious about paying down their debts, get so charged up — pun intended — that they want to devote every dollar to their debt payoff. They want to clean out their savings accounts. I love the enthusiasm.
So that brings me to the next question: Should I still save when I’m trying to pay off my debt?
If you’re deeply in debt and that debt carries high interest rates, it doesn’t make much sense to keep a huge rainy day fund in a bank deposit account earning a puny amount of interest. Dig yourself out of debt by letting go of some of the cash to get rid of the debt. Note I said “some” of the debt.
If you don’t have any savings, you absolutely should save something while getting out of debt. I know: You’re thinking, “But the interest rates on the debt are killing me, so I should get out of debt as quickly as possible.” And you would be right — mostly.
But if you don’t have some savings to fall back on and a financial crisis comes up, what are you likely to do?
You guessed it.
If you can, you’ll probably turn to your credit cards, get another loan or borrow it from a family member or friend. A Federal Reserve survey found that about 46 percent of Americans didn’t have enough savings to come up with a $400 emergency expense.
So yes, folks, you absolutely need some savings to keep from undermining your debt-payoff momentum. Unless your job situation is unstable, just aim for $1,000 or $2,000 in savings. Then stop saving and devote the rest of the money you find in your budget to paying off your consumer debts.
Should I Pay Off the Debt With the Highest Interest Rates Frst?
Finally, should I pay off the debt with the highest interest rates first?
When it comes to paying off debt, there are lots of opinions and strategies. Many financial experts will tell you to list your debts starting with the ones with the highest interest rates. The goal, they advise, is to cut your finance charges. And that math makes sense.
But I never really understood how we expect people to act rationally when getting out of debt, when the very fact that many are struggling with loans or credit card debt stemmed from irrational behavior.
After spending years working with hundreds of people trying to climb out of debt, I’ve found the best strategy for debt payoff is behavioral modification, over the math.
So list your debts from the smallest to the largest. You will start paying off the debt with the lowest balance. All extra money you find will be used to attack the top-listed debt. And while you are concentrating on this debt, you’ll only make the minimum payments on the others on the list.
Using this strategy, people get rid of some debt quickly. That in turn motivates them to become even more aggressive in getting out of debt. So even though they didn’t start with the debts with the highest interest rates, they still cut that expense because they got out of debt quicker.
Paying off debt is more than just math. You’ve got to psych yourself out. Use strategies that will help you remember that being in debt is awful and you’ll do whatever you can to stay as debt-free as possible.