Create a debt repayment plan

In December and January, The Simple Dollar is posting a daily series focusing on specific activities you can do right now to set the stage for a great 2011. Out with the old, in with the new.

6. Create a debt repayment plan.

Yesterday, we talked about the usefulness of cleaning up your debts. Doing this reduces your interest rates (and thus the total amount of interest you’re paying to the companies), reduces your monthly payments, and reduces your risk of identity theft.

Of course, now that you have this reduced set of debts with a smaller batch of monthly payments, you’re in a perfect position to start tossing some of that savings toward eliminating those debts. The faster you get rid of those debts, the faster you’ll be in complete control of your financial future and the less you’ll have to pay on the whole to companies in the form of interest.

The way to do that is with a well-thought-out debt repayment plan.

Getting Ready
Developing such a plan is easy. You simply need a list of your debts, their balances, and their interest rates. If a debt has multiple rates, I usually encourage people to use the highest rate for that debt.

If you followed yesterday’s plan of minimizing and organizing your debts, this list should already be in front of you.

Ordering Them
The next step is putting the debts in the order in which you intend to repay them. There are two different schools of thought as to the order with which to repay them.

The Dave Ramsey “debt snowball” method encourages people to order their debts by their balance, smallest to largest. The reason for doing this is so that you experience the “success” of paying off a debt as quickly as possible so that you have the motivation to keep going.

The mathematically superior method encourages people to order their debts by their interest rate, highest to lowest. This method will result in your debts being paid off the fastest, but it can often be a long slog, particularly if your highest interest debt is a very large debt.

I don’t really think you can go wrong with either method. They each have advantages and disadvantages.

Executing the Plan
There’s one final thing you need to have before you start this plan: how much can you throw towards it per month?

That amount should be at least as much as you were throwing towards your debts before you cleaned them up. Ideally, you’re doing a little more than that.

So, let’s say you were spending $1,500 a month making minimum payments on your debts. After cleaning them up, your monthly payments are now $1,100. You should still aim for putting $1,500 a month towards it.

Treat that total amount as a bill that is without question. You have to pay that extra amount. If you start to fudge on it, all you’re doing is ensuring yourself a debt-filled future.

So, you have $1,500 in debt payments and $1,100 in minimum payments this month. That means you have $400 extra. You just add that $400 to your payment on the first debt on your list that month, giving the balance of that debt a good whacking.

What will happen is that over time, you’ll see the balance of that first debt dropping like a stone. Soon, it will be paid off.

At that point, your minimum payments might be $1,000. You should still be using $1,500 a month in debt payments, so now you have $500 extra per month. Cross off that paid off debt and, now, apply that extra $500 to the new top debt on your list.

This is basically the procedure you repeat until you’re debt free. You just keep alloting a large chunk towards debt repayment each month. Each month, make minimum payments on all of your debts, then make an extra payment on the debt at the top of your list. Rinse and repeat and watch the debts melt away.

Today is your day for getting such a system in place. Get rid of those debts that are constantly draining your wallet each and every month.

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