After decades of spending beyond their means, many Americans are now trying to gain control of their finances and are pursuing a debt-free lifestyle. Many strategies have been proposed to facilitate this trend in personal financial planning.
Like most financial planning techniques, one strategy does not fit all. The primary factor in determining the best tactic for your situation is to consider motivation. Motivation is the greatest single factor in keeping you on a debt-free course until you reach the finish line.
There are three primary strategies to consider. Regardless of which one you choose, remember: all of these strategies require that the minimum payments be paid consistently and on-time for each and every debt account. Only surplus monies should be budgeted for further debt reduction. In addition, the best way to become debt-free as quickly as possible is to stop using credit for any purchases or bill payments immediately.
Balance Amount Strategy
A popular strategy to becoming debt free is paying off debt smallest to largest. Using this technique, borrowers list their debts in order of size, without consideration of interest rate. Initially, the borrower budgets to pay the minimum payment on all debt and then applies any surplus monies to the smallest debt. Once, the smallest account is paid off, all monies being applied to that account are applied to the next smallest debt.
For borrowers who need to see quick progress, this strategy provides the benefit of seeing one debt extinguished fairly rapidly. Much like dropping five pounds in the first week of a diet, quickly discharging even one debt can be a great motivator for certain people on a debt-free diet plan.
Interest Rate Strategy
For other borrowers, getting rid of high interest rates can provide a better incentive to continue down a debt-free path. Once I realized I was paying more than $100 per month in interest on a single credit card, I became obsessed with erasing that debt. Credit cards that only cost me a few dollars in interest did not ignite that same fire in me. Again, motivation is the key factor in following all the way through on any debt-free plan.
In order to properly use this strategy, begin by listing all debt in order of interest rate. Apply any surplus money to the debt with the highest interest rate. Once that debt is extinguished, start on the debt with the next highest rate.
It will probably take you longer to totally eliminate that first debt instrument than using the account balance strategy. However, as you reduce the interest charges, more of your payment will be applied to principal each month. While you may have to delay the gratification of seeing a debt totally eliminated, this method should actually cost you less money in the long fun than the account balance strategy.
Loan to Limit Ratio Strategy
Finally, for some borrowers, the most important factor is improving their credit ratings. Credit ratings can affect many financial situations besides the cost of debt, including insurance rates on both home and car policies and even employment opportunities.
If improving your credit rating is a high priority, the best way to accomplish this is to list your debts as to how close each balance is to the credit limit assigned to that account. Begin your debt-free strategy by using all surplus money to the account closest to its credit limit. Credit reporting agencies use a utilization ratio as one factor in calculating credit scores. By reducing your ratio, your credit score should begin to improve.
By basing your debt-free strategy on your own personal motivation and priorities, you will increase the chance that you will follow it through to completion. And, in the case of debt-free living, the end is more important than the means.
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