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3 approaches to paying off debt

Dear Debt Adviser,
I am concentrating on paying off debt. I have read two different approaches: 1) Pay off similar debts first making minimum payments on others. As debts are paid off, apply payments to next size debt. 2) Same idea except pay off highest interest rate debt first. Which in your opinion is best approach?
-- David

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Dear David,
I like your thinking on this situation. Both approaches are logical and can work, if they satisfy your perception of progress. I also want to suggest a third approach for your consideration.

I am going to assume that you meant smaller, as well as similar in amount, debts in your first example. Here, you are able to make a quick dent in your situation that is easy to see. Once company "A" is paid off, you would move on to company "B" and so forth. This is a good method for consumers who have a great number of accounts, because once you pay off "A" you will have a visible success and never have to think of it again.

Paying off a debt completely is very satisfying and can make a person feel that progress is being made toward becoming debt-free. In addition, consumers who are overwhelmed by the sheer number of payments they have to make every month, and the accounts they have to keep up with, might like to go with this plan.

Your second scenario actually makes more sense from a pure dollars-and-cents approach. Paying off those debts that are costing you the most in interest lets you keep more of your money in the long run. A credit card debt of $5,000 can easily run you $80 in interest every month.

Although you might have a credit card with a small balance and could pay it off immediately, the amount you pay in interest to the higher-rate or balance card would be higher, and your indebtedness would be higher for longer, if you were to split your payment over multiple cards. If you devote your excess money, over the minimum payment, to the high-rate card, you will see your principal amount shrink faster and ultimately save more. The key here is to NOT reduce your overall payments when you pay off a debt. Apply those "savings" to the next-highest debt. Create a "payment snowball" that keeps building as you go, and you pay everyone off faster.

A third way to look at this is to consider your credit score. If you are planning on applying for a loan in the foreseeable future, the effect of how you pay down your bills may save you more than the amount of short-term interest savings approach. Credit scores look at a number of factors and one is, what percentage of a credit card's limit is owed. If you owe more than 50 percent of the limit, you lose points. So paying down the balances so all of them are below 50 percent of maximums will help your score and might save you some serious money on longer-term loans. Be sure that all of the accounts are less than 50 percent, as even one can make a difference.

Still, in the end, this is really a personal preference, David. Like dieting or working out, the plan has to satisfy you. The really important part is having a plan that fits you, feels good and you will stick to. For the last few months I've been going to the gym to build up my aging muscles, not to lose weight. Now that I am a little firmer however, I am thinking more of the weight issue. So, remember priorities can change, and that's fine. You know best what your circumstances are and what will work for you. No matter what, you are doing the right thing to begin the process of becoming debt-free.

Good luck!

The Debt Adviser, Steve Bucci, is the president of Money Management International Financial Education Foundation and the author of Credit Repair Kit for Dummies. Visit MMI for additional debt advice or click here to ask a debt question.

Bankrate.com's corrections policy -- Posted: Nov. 4, 2005
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