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## Paying Down Debt

The School of Hard Knocks has probably taught you one of the four decision-making approaches used to pay off or pay off debt. With this knowledge, you are ready to fiscally steer your home or business down a path that will only go wrong about 75% of the time.

Debt can be good. It generates credit, enables expansion, closes gaps and finances education. An excess of debt, on the other hand, can affect a family budget or a business. Once you’ve made the decision to reduce debt, this short guide will help you determine how best to achieve your goal.

In very simple terms, to reduce debt you must first be able to pay all the minimum payments on each debt and other monthly expenses. After that, you need to have additional “debt reduction” funds to apply to one of the debts with the intention of eliminating it. Additional funds can be in large amounts or in smaller amounts over time. The size of the money pot is less important than the process. A bigger pot will help you reach your debt reduction goals faster; however, a smaller pot, used correctly, will still get you going in the right direction.

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

__Interest rate approach__:

The demagogues of modern mythology have most likely taught you the first of the four approaches through magazines and trade magazines 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 vehicle loan is 6.0% and the credit card is 5.5%, you choose to pay the debt reduction funds towards the loan d ‘higher interest: the mortgage.

The reasoning behind this approach is sound and the math is simple. Not bad; it is simply incomplete as it represents only one tool in your toolbox to be used when your goal is to reduce the total interest paid. And just as a hammer is a wonderful tool, it doesn’t help much to remove a screw or cut a board in half.

__Balance 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’ve paid off the first debt, other things being equal, you can now add the monthly payment you pay on that debt to the original debt reduction payment, which can now be applied to the second debt. The balance sheet approach, then, guides you to pay off debt with the smallest remaining loan balance when your goal is to reduce the number of debts owed. So, if the mortgage balance is $258,000, the vehicle loan is $3,500, and the credit card is $8,000; pay off the vehicle loan first. This will allow you to combine the payment you were making on the vehicle loan plus the additional debt reduction payment towards your next debt, whether it’s your mortgage or 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 you to reduce borrowing which will reduce monthly cash flow; that is, the amount you have to pay each month as the sum of all your minimum payments. Mortgages and car loans are usually installment loans, so even if you make a significant payment above the minimum this month, you still have to pay the same minimum payment next month. In contrast, credit cards, lines of credit, and interest-only loans adjust your monthly payment amounts based on the balance owed. So, if the minimum monthly mortgage payment is $2,100, the vehicle loan is $650, and the credit card is $200; pay by credit card first.

As your credit card balance is paid off, your minimum payment amount will decrease, taking less cash out of your finances. This allows for maximum flexibility if things take a turn for the worse, opportunities arise or plans change.

__Risk reduction approach__:

Lenders classify debt based on risk exposure and you should too. While your plan may be to completely eliminate all debt, plans change. In the future, you may find yourself back in front of a lender asking for another loan, perhaps to refinance a loan at a better interest rate. This will likely happen before your total debt elimination plan is fully realized. Prepare now for that likelihood 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 classify the debt as “secured” and “unsecured.” Secured debt is backed by collateral that the lender can repossess or foreclose on if you fail to hold up your end of the business. This can be complicated, as lenders further classify secured debt based on the value of the collateral, how the collateral typically appreciates/depreciates, and the ability to resell it. For this reason, a well-maintained building is better collateral than undeveloped land, and both are better than a vehicle which, in turn, is better than a boat. The better the collateral, the less risk associated with the debt. As you might suspect, unsecured debt is unsecured. He has nothing to do except your word that you will pay. Unsecured debt is therefore the riskiest debt.

Continuing with the example above, using the risk reduction approach: pay off the credit card first, then the vehicle loan, then the mortgage.

__The best approach for you__:

As you can see, each approach can produce a different answer about which debt to reduce first. Unfortunately, just as there are no magic wands, there is no best approach. All four approaches have great merit and can produce the “right answer.” In the end, it is up to you to decide on the prudent financial management solution to achieve your goals. Run the analysis with each tool. Explain the results for your particular situation. Balance what you find against your personal strengths and weaknesses as you weigh possible future scenarios. Then make a decision! No decision you make to reduce debt will be wrong, it will only minimize the total interest paid, reduce the number of debts owed, add more flexibility to your finances or prepare you to apply for another loan. Whatever decision you make, make it today.

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