My closest is a great example of a project that went and will probably stay unfinished. I have a pile that needs to go to goodwill, books that need posting on Paper Back Swap, wires that I’m not sure of their purpose, and unfortunately a lot more random things.
When I started the project of cleaning my closet, I had momentum. About an hour later, I got hungry and my momentum was lost.
Phase 2 of your personal financial plan isn’t easy. There will be many times in which you will lose interest and want to give up. However, it’s important you find a way to maintain your momentum as you work you way to financial independence.
Phase 2 consists of two steps:
- Get out of debt
- Begin the habit of a monthly review
Getting Out of Debt
The simplest method to pay off your debt is to list each debt in order from the highest to lowest interest rate and pay the most you can on the debt with the highest interest rate. Even though that method might make the most sense to your math teacher, it probably won’t make the most sense towards your psychology teacher.
Paying off debt isn’t something you do in a week. It might take 6 months or 30 years depending on your circumstances. You’re going to need motivation to get from start to finish.
The debt snowball is all about creating momentum. Instead of listing your debts in order of interest rate, you list them in order from the smallest to largest balance. On every debt besides the smallest, you pay the minimums. On the smallest debt, you put everything you have towards eliminating that debt.
The debt snowball combined with snowflaking is when you really can make progress fast. Snowflakes are little gains that will eventually create a snowball. Little gains like selling something on eBay, having a garage sale, or working some overtime go directly to paying off debt.
Combined, these two methods will get you to the finish line the fast.
Pay Off All Debt or Only High Interest Debt?
There is a school of thought that before moving beyond stage 2, you should pay off all non-mortgage debt. The other way of thinking is to pay off only high interest debt before moving on.
Unfortunately, I’m not going to give you a simple rule of thumb to base your decision on. Instead I think it’s important to describe the principles behind the decision and let you decide which method is best.
First, paying off all debt before moving to the next phase is an excellent financial decision. Especially when the obligation to pay off debt is holding you back in areas of your life. For example, if you’re stuck in a job you dislike because of your obligation to pay off your debt.
The disadvantage of paying off all debt is that your investments, discussed in phase 3, don’t get as many years to compound.
Your second option is to pay off high interest debt only in phase 2. Therefore, before moving to phase 3, you will have to payoff only high interest debt.
The advantage is you get a few more years for your investment to compound. The biggest disadvantage is that you still have debt, which among many other things restricts some of your options.
The last thing to remember in your decision is that both methods are an investment. If you make extra payments towards a debt with an interest rate of 8%, that’s equal to earning 8% after-taxes on an investment.
Unfortunately, that takes us to the to the math teacher vs. psychology teacher debate. The math teacher will tell you that statistically it makes the most sense to pay off only debt above what the market has historically returned, about 10%. The psychology teacher will tell your best chance of success will come from paying off all debts before moving on.
There is no right or wrong way. Choose whatever method you feel you have the greatest chance of success.
Monthly Reviews and a Net Wealth Mindset
The second part of phase two is the monthly review.
The monthly review is another momentum builder. The purpose is to give you statistics that to let you know of your improvement from the previous month.
The monthly review is a three step process:
- Review and analyze budget
- Calculate your net worth and net wealth
- Put money towards your goals, which for now is to pay off debt
In depth explanation of monthly review.
This is the 2nd of 6 phases of a personal financial plan. On Wednesday, I will post Phase 3.
Please leave a comment if you have had success or failure with a particular method to pay-off debt.