If you want to eliminate debt, blindly making the minimum payment because you don't know where to start is one of the worst things you can do. If you have a large amount of debt, or have many sources of debt, creating a plan to pay it off is a huge step to living debt free. Trying to figure out the best way to pay it off can seem overwhelming when you are overloaded, especially with all the “get out of debt fast” schemes out there.
A debt payoff plan includes figuring out what debt you have to pay, in what order you need to pay them, and how much you need to pay to eliminate them. By creating this plan and following these steps, you will create a plan that is not only realistic to your lifestyle, but one that will fit within your personal budget as well. If you feel overwhelmed by your debt, are only making the minimum payments, and are seeing no results, then it's time to create a debt payoff plan.
Step #1: Make a Debt List
The first step in creating a plan to pay off debt is to calculate what debt you have, what you owe, and how much you owe. There are a couple of ways you can do this. If you don't pay much attention to the debt you have, you can grab your free credit score here. Your credit report will list all of your debt obligations from companies that report to all 3 major credit bureaus. If you are relying only on your credit report to know what debt you have, be aware that it might not list all of your debt. Make sure to go through past statements from your creditors so you can add these to your list as well.
Take out a piece of paper, or use the FREE Debt List worksheet to write down who you owe, the amount you owe, the minimum payment for each debt obligation, the interest rate (list from highest to lowest), and your monthly due date. Once you have a clear picture of your debt & depending on your priorities, you might decide to really only focus on the “bad” debt. This debt includes things like credit cards and small personal loans. These debts will most likely have the highest interest rates as well.
Step #2: Figure Out Your Debt Priorities
Deciding on what debt you want to pay off first is the next huge step. There are a couple of different methods you can use when determining what debt you want to tackle first. Before I tell you what method I prefer, let's look at what the 2 methods are.
- Pay off high-interest debt first using the Avalanche Method: Using this method, you pay off your debts from highest interest rate to lowest interest rate. You tackle the higher interest debt first, regardless of the balance. Using this method makes mathematical sense because you will pay less interest overall. By doing it this way, and because you are saving more in interest, you will be able to pay off your debt more quickly.
- Pay off debts with the smallest balance first using the Snowball Method: Using this method, you pay off debts from smallest balance to largest balance regardless of interest rate. When you have a ton of debt statements coming in every month and are having a hard time keeping track of all your little debts, it can be overwhelming. Using this method is supposed to relieve some of that stress. It may seem like no matter where you turn you owe money and this can seem daunting. By paying your smallest balances first you can get rid of a bunch of your little debts very quickly. This gives you motivation and instant gratification because you immediately see progress. Plus with all of your little debt gone, when you start to tackle your bigger debts, you will have the extra cash flow to do it.
So now that you know the 2 most common ways to prioritize your debt, I will tell you that I think the best way to pay down debt is by using the Avalanche Method. I am a numbers person, and saving interest in the long run makes the most sense to me. The truth is, whichever method you choose, making the decision is the most important. You have to use a method that will keep you motivated to keep at it. So if you want to optimize your payments and saving on interest is a priority, then use the Avalanche Method. If think paying off your smaller debts will keep you motivated, use the Snowball method. Even though the argument is strong for both methods, you always have to do what's best for you. So take out your Debt List and make sure to prioritize and rank your debts. For this example, I am choosing to pay off the highest interest rate debt first.
Step #3: Determine How Much You Can Pay
The next step in your debt payoff plan is figuring out how much you can afford to pay on your debt. The only way to complete this step is by having a workable budget. Now, if you are wanting to save while you are paying off the debt, then you have to figure out how much you are comfortable paying toward debt without restricting your ability to live a happy life.
The first thing to figure out is your discretionary income. This is the income that is left over after you pay necessary expenses such as food, transportation, housing expenses, gas etc. You use discretionary income to establish an emergency fund, debt payment plan, or use it to fund other saving goals. The thing I want you to remember for this step is that not all of your discretionary income has to go towards debt. It's all up to you. If the most important financial factor in your life is paying off your debt, then you can use all of your discretionary income. But if you are wanting to also fund an emergency fund at the same time, then you can choose to have 80% of your discretionary income go towards debt and the other 20% towards savings.
Total all of your income which includes things like the salary from your job, alimony, child support, guaranteed bonuses and other income sources. Then subtract this amount from your monthly expenses. Your monthly expenses will include things like your monthly rent payment, phone bill, groceries, and clothing purchases. The amount you have left over after you subtract your income from expenses is what you can use to pay down debt (or build your savings). Use the FREE budget template below to create a simple working budget.
Download the PDF version HERE
Download the Excel version with formulas HERE
Step #4: Start the Plan
Now that you know how much you can put towards debt, put the plan into action. Use the amount you came up with in Step #3 and apply it towards your priorities. This will either be paying the smaller balances first or the highest interest debt first. Continue to make your monthly minimum payments that you calculated in Step #2, but use all the leftover money you just calculated towards debt priority #1.
For example: In the example above, I calculated that I have $605 leftover to pay off debt. If you also want to save for other things while paying off debt, make sure to add that saving amount as an expense in your budget (see the above example). The first debt I want to tackle is my Target Credit Card since it has the highest interest rate. So not only will I make my minimum monthly payment of $150 every month, but I also pay $605 every month from the leftover money I have from calculating and creating my budget. So I will make a total monthly payment of $755.
Once you pay off your first debt priority, simply move onto the next one. Use the amount that you were putting towards debt priority #1 and apply to debt priority #2.
For example: If you were making a minimum payment of $150 every month like the example above, once priority #1 is paid off, apply that minimum payment to debt priority #2. So not only will you be applying the extra money from your budget that you calculated in Step #3, but you will also be using the minimum payment amount from priority debt #1 that you just paid off.
To recap: you are going to use the monthly payment from the debt you just repaid + the minimum payment you were already paying and you are going to put the combined payment towards the next debt. Complete this process until all debt is paid off. You can complete the FREE debt payoff worksheet or simply use paper and pen. You can also find out how long it will take you to pay off your debt by using this debt payment calculator.
Step #5: Update and Inspect
It's never enough to just put your plan into action. You have to also come back to your debt payoff plan regularly. It can take years to pay off bigger debts, so making sure your plan changes with your circumstances is important. If your income changes, your budget needs to be updated as well. Make sure to revisit your plan as you continue to make payments. You also have to make sure to make necessary changes as your financial situation changes as well.
Don't beat yourself up if you make mistakes or get discouraged if you run into setbacks. The most important thing to remember is to pick yourself up and continue with your plan as soon as you can. Throughout this process, you should develop positive financial habits by completing financial steps consistently. Debt can be overwhelming, but having a plan can really relieve some stress and give you hope. Today, take the first step in tackling your debt and create a plan to live debt free.
- Resource: Vertex42 Debt Reduction Calculator
How have you started paying off debt?