The No Debt Plan: Step Four: Pay Off All Consumer Debt

by Kevin on June 18, 2008

This has been a long time coming. I’ve been meaning to write this for weeks. You can read more about The No Debt Plan, or get caught up on the first few individual steps.

If you’ve been following the steps of the plan, this is where you should stand:

  • You should have a budget, and know where every dime has gone in the past few months. Your budget should tell you where each dime is going to go this month as well.
  • You’ve done whatever it takes — cutting of expenses or increasing your income — to achieve free cash flow.
  • You have some sort of emergency fund. It could be $1,000 as recommended by Dave Ramsey, or 3-6 months of expenses. Each situation will be different. Do what seems prudent for your family situation. If you have debt, I wouldn’t put more than 6 months away as that may take you a long time.

If you haven’t yet achieved those things you can go back to the steps linked above to catch up. Now, Step Four…

Pay Off All Consumer Debt

Consumer debt is the bane of my existence. Not for me, but for you, my readers. Consumer debt is defined by InvestorWords.com as:

“Debt that has been incurred primarily for the purchase of consumer goods …”

So anything that isn’t your house counts as a consumer good. Some might even consider a house as a consumer good depending on why you bought it.

If you purchased something because you couldn’t wait to save up for it, and you paid interest for it (or still are!) that’s consumer debt.

Some quick examples:

  • That 46″ LCD High definition TV that you bought on your Best Buy credit card. Interest rate of 19.99%.
  • The new BMW sitting in your driveway, payments of only $499 per month.
  • A new iPhone that you put on your credit card for two months with interest at 14.99%.

All of the above are poor financial choices. You’re paying interest on goods that over time will be worth less than they are today.

How to Tackle and Pay Off Your Debt

There are several popular methods to pay off your debt. Dave Ramsey says to go after the smallest amount first regardless of interest rate. Suze Orzman does the opposite. She wants you to pay the minimum payment plus $10 to every debt, then any remaining to the debt with the highest interest rate. You can see a great comparison of the two methods at The Simple Dollar.

So what should you do? What do I recommend?

Do something. Either of the above are fine. I’d rather you start paying extra on your debt whichever way possible. However, tweaking Suze’s method is by far the best mathematically.

3 Steps to Pay Off Debt:

  1. Rank your debts in order from highest interest rate to lowest interest rate.
  2. Pay the minimums on all debt.
  3. Any additional money goes towards the debt with the highest interest rate.

Mathematically, this is the least expensive option because you are actively paying down the debt that is costing you the most every month. It is also the fastest method bearscause you acrue the smallest amount of interest versus the other methods.

Psychologically, it may feel better to pay off several small debts very quickly. I’m not here to make you feel good. I’m here to get you out of debt. I’m not sure why Orzman wants you to pay an extra $10 toward every debt. That’s not going to make a huge difference in interest saved.

Pay off the highest interest rate debt first, and move your way down. And good luck. This step may take some of you years to run through. That’s the consequence of past actions. But stick to it… the grass really is greener on the other side.

{ 2 comments… read them below or add one }

steve in w ma October 9, 2009 at 12:32 pm

Orman suggests paying $10 more than the minimum because the credit card companies will report that as “consumer paid more than the minimum” to the credit reporting agencies, which is better for your credit score. In effect, Orman is suggesting that you always make your “minimum” payment the credit card’s suggested minimum plus $10.

She doesn’t mean that’s all you should pay, she means that’s the *least* you should pay.

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Goldruch August 4, 2010 at 5:38 pm

You will feel better to pay off several small debts very quickly, and if you have large amount of debt let say from $10,000 and above and your struggling to pay, your better of settling your debt with bank.

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