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## Paying Down Debt

The school of hard knocks probably taught you one of the four decision-making approaches used to pay off or repay a debt. Armed with this knowledge, you are ready to tax lead your household or business down a path that will only be wrong about 75% of the time.

Debt can be good. It strengthens credit, enables expansion, fills gaps and funds education. Too much debt, on the other hand, can weigh down a family budget or a business. Once you’ve made the decision to reduce your debt, this short guide will help you determine the best way to achieve your goal.

In very simple terms, to reduce debt, you must first be able to pay all 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 be in large or small amounts over time. The size of the pool is less important than the process. A bigger pot will help you reach your debt reduction goals faster; but, a smaller pot, used correctly, will always lead you in the right direction.

The question becomes: if you have multiple debts (e.g., home mortgage, car loan, and credit card), which do you pay off first? There are four decision-making approaches that help you identify which should be paid first: the interest rate approach, the balance approach, the cash flow approach and the reduction approach. risks.

__Interest rate approach__:

The demagogues of modern mythology most likely taught you the first of the four approaches through magazines and trade journals or on radio and television. Pay off the debt with the highest interest rate. So, if the mortgage has an APR of 7.4% while the car loan is 6.0% and the credit card is 5.5%, choose to pay debt reduction funds on the loan at highest interest – the mortgage.

The reasoning for this approach is sound and the math is straightforward. It’s not false; it is simply incomplete because it represents only one tool in your toolbox to use when your goal is to reduce total interest paid. And, just as a hammer is a wonderful tool, there’s no point in removing a screw or cutting a board in half.

__Balanced approach__:

The beauty of debt reduction is the snowball effect that allows future debt reduction payments to be much larger than the initial payments. Once you have paid off the first debt, all things being equal, you can now add the monthly payment you were paying on that debt to your initial debt reduction payment, both of which can now be applied to the second debt. The balance approach then guides you to repay the debt with the smallest remaining balance on the loan when your goal is to reduce the number of debts owed. So if the mortgage balance is $258,000, the car loan is $3,500, and the credit card is $8,000 – pay off the car loan first. This will allow you to combine the payment you were paying on the car loan and your additional debt reduction payment towards the next debt – either the mortgage or the credit card.

__Cash flow approach__:

The only consistent thing in life is “change”. Just as you need to be flexible in life, you should strive to add more flexibility to your finances. The cash flow approach teaches to reduce the loan which will reduce the monthly cash flow; that is, the amount you must pay each month as the sum of all your minimum payments. Mortgages and auto loans are often installment loans, so even if you make a large payment above the minimum this month, you’ll still owe the same minimum payment next month. In contrast, credit cards, lines of credit, and interest-only loans adjust their monthly payment amounts based on the balance owing. So if the minimum monthly payment on the mortgage is $2,100, the car loan is $650, and the credit card is $200 – pay on the credit card first.

As the credit card balance is paid off, the minimum payment amount will decrease, causing less money to flow out of your finances. This allows for greater flexibility if things go wrong, opportunities arise, or plans change.

__Risk reduction approach__:

Lenders categorize debt by risk exposure and so should you. Even though your plan may be to totally eliminate all debt, plans change. In the future, you may find yourself with a lender looking for another loan, perhaps to refinance a loan at a better interest rate. There’s a good chance this will happen before your total debt elimination plan is fully realized. Prepare for this probability now by paying off high-risk debt first to reduce your overall cumulative risk so that lenders are more likely to grant you that future loan.

Lenders first categorize debt into “secured” and “unsecured”. Secured debt is secured by collateral that the lender can repossess or seize if you fail to keep your end of the bargain. This can be complicated because lenders further categorize secured debt based on the value of the collateral, how the collateral normally appreciates/depreciates, and the ability to resell it. For this reason, a well-maintained building is a better guarantee than unbuilt land, and both are better than a vehicle, which in turn is better than a boat. The better the collateral, the lower the risk associated with the debt. As you might expect, unsecured debt is unsecured. He has nothing to back him up except your word that you will repay. Unsecured debt is therefore the riskiest debt.

Following the example above, using the risk reduction approach – pay off the credit card first, followed by the car loan, then the mortgage.

__The best approach for you__:

As you can see, each approach can produce a different answer as to which debt to reduce first. Unfortunately, just like there is no magic wand, there is no best approach. All four approaches have great merit and can produce the “right answer”. Ultimately, it is you who must decide on the prudent money management solution to achieve your goals. Run the analysis using each tool. Lay out the results for your particular situation. Balance what you find against your personal strengths and weaknesses while evaluating possible future scenarios. So make a decision! No decision you make to reduce your debt will be bad, it will simply minimize your total interest paid, reduce the number of debts owed, add more flexibility to your finances, or prepare you to seek another loan. Whatever decision you make, make it today.

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