Principles of Pollex: Debt Reduction

Photo credit: jb

(In case you’re confused by the headline: a principle is a rule, and pollex is an obscure term for thumb. Therefore, this series is all about Financial Rules of Thumb.)

Try as we might, there are times when debts just overtake us. Quite often it is one of several things that causes this to happen – either we’ve had unexpected expenses hit us “alla sudden-like”, or perhaps a layoff or lean time with little or no income. Or maybe we just didn’t pay attention and debt grew out of control.

How’d I Get Here?

The reason we’re in this position is important, because we can’t let the debts continue to increase – so the first order of business in reducing your debts is to stop the bleeding. Figure out what the cause of the debt was, and work out a way to stop increasing the debt (if possible). If it’s just regular spending, shopping and the like, you need to get a handle on your outflows, or come up  with a way to increase your income so that you’re not adding to the debt load. Whatever the cause of the debt in the first place, you need to stop it from increasing.

I recognize that folks with high medical expenses (for example) are not in a position to reduce the outflows. In a situation like that, godspeed to you, hope your situation improves.

After you’ve stopped your debt from increasing, it’s time to come up with a plan to start reducing the debt load. In order to do this, we go back to the time-honored method of Organization, Efficiency, and Discipline to work through your debt reduction.

Organization

To start off with, you need to Organize. List all of your debts, including the balance, interest rate and minimum payment for each. You can do this on a sheet of tablet paper, or on a spreadsheet like Excel or Google docs. Once you’ve listed all of your debts, you can tally up your total amount that you owe, as well as how much your monthly cost is at a minimum.

For many folks this is the first time they’ve put it all together in one place, and it can be a bit scary. What’s important is that now you know where you are… and of course, where you’re going is to take that balance down to zero. It becomes a matter of filling in the space in between.

One way to do this is to just make the minimum payments every month, and eventually you’d pay it all off. But there are better ways to go about this, more efficient ways, especially if you have a little extra to pay each month above the minimum. If you don’t have any extra, consider eliminating some other monthly expense, or selling an item (or items) that you no longer use.

Efficiency

Let’s use a very simple example – say you have three debts, totaling $200 each, at rates of 10%, 15%, and 20% respectively. These three debts each have a monthly minimum payment of $10 each. If you paid the minimum on each debt every month, you’d pay off the 10% debt in 24 months, the 15% debt in 26 months, and the 20% debt in 27 months. But let’s say you have a total of $40 to apply toward debt each month…

If you split the $40 evenly between the debts, now your 10% and 15% debts would be paid off in 19 months and the 20% debt in 20 months. Pretty good deal, right? You’ve shaved 8 months off the time to pay it all off. But there’s a better way to do this.

What if you took the extra $10 and paid it toward the highest rate first? Now the 20% loan would be paid off in 14 months. Then, if you took the $20 that you’d been paying toward the 20% debt and added that to the $10 minimum that you’d been paying on the 15% debt (so that the total payment now is $30), that debt would be eliminated by the 17th month. Adding that $30 to your 10% debt payment, you’d be finished paying off that debt by the 18th month.

Not only have you shortened the timeline by a month, but by paying the highest rate debt first, you’d reduce the overall cost of the debt earlier. This method is known as a “debt snowball”.

Discipline

The debt snowball will only work if you stick to it… and the whole idea of debt reduction requires discipline in order to make it work. If you start off on the project and free up some of your credit line, only to build up the debt again, you’ll be back to square one again before you know it. This is why I mentioned at the start that you need to understand how you got into this debt position in the first place. If you’re simply spending far more money than you can bring in with your income, you have to figure out a way to fix that situation. There is no way to resolve this problem without either bringing in more money or reducing your expenditures.