What’s the best way to get out of debt?

February 24, 2013 at 2:20 pm Leave a comment

 

bob3More and more Canadians view getting out of debt as their main financial priority – even at the expense of retirement planning, according to a recent CIBC study.

 

Seventeen per cent of participants selected debt reduction as their main priority in 2013, unchanged from 2012 and marking the third year in a row that debt reduction has landed at the top of the list.

 

What’s particularly interesting is that the age groups where retirement planning has traditionally been a top priority have also shifted their focus towards debt reduction.

 

Two years ago, 24 per cent of those aged 45-64 chose retirement planning as their top financial priority, but just 12 per cent ticked that box in this year’s study. At the same time, debt management jumped from 14 per cent in 2011 to 18 per cent today.

 

The good news is that Canadians seem to be paying off their debts faster, with the number of those more than three months behind on their loan payments dropping to a record low, according to Equifax Canada.

 

Average credit card balances dropped by almost four per cent in the final three months of 2012 compared with the previous quarter — a sign that at least some people are trying to pay off their plastic a bit more quickly.

 

All of which begs the question: What’s the best way to whittle away at those debts, particularly when you’re juggling high-interest credit cards?

 

Logic says that you should pay off them off in order of interest rate, attacking those with the highest interest charges first, while paying the minimum on your other debts to avoid late charges and penalties.

 

But that can be a very steep hill to climb. As a result, some people prefer to pay off their smaller debts first, regardless of the interest rate. This is known as the “snowball” approach, popularized by radio host Dave Ramsey, author of The Total Money Makeover.

 

“When you were a kid rolling a snowball in the backyard, the best way to do it was to pack some snow into a tight ball, then start rolling it through the yard,” Ramsey says. “Your snowball would become a snow boulder much quicker than it would if you just built it up by hand.”

 

You can create the same effect by making minimum payments on all but the debt with the lowest balance, Ramsey believes. Once the low-balance debt is paid off, you add the dollars that you’ve directed there to what you’ve been paying against the next lowest debt. And so on.

 

Ordering your debts by balance means you get a bigger psychological boost by seeing the number of your debts reduced, Ramsey maintains, arguing that most people need some quick wins in order to stay pumped up.

 

“Paying off debt is not always about math. It’s about motivation,” he says. “Personal finance is 20 per cent head knowledge and 80 per cent behaviour. When you start knocking off the easier debts, you’ll see results and you’ll stay motivated.”

 

And that is how most people think, suggests Cynthia Cryder, a marketing professor at Washington University in St. Louis.

 

Throughout a series of experiments, she and a group of researchers found that participants consistently paid off their small debts first, even though the larger debts highlighted in the study had much higher interest rates.

 

Still, “while it’s attractive to close an account, that’s not necessarily the best approach to minimizing your debt burden,” Cryder says. The correct path to reducing overall debt is to always put extra money toward the loans with high interest rates, she advises.

 

Showing subjects the total amount of interest they’d end up paying helped spur most of them to pay off the card with the higher interest rate first, as did consolidating some smaller debts, she says.

 

To do otherwise is to end up winning the battle, but losing the war, she concludes.

 

If you’re working through multiple debts and simply aren’t sure which strategy will work for you, check out What’s The Cost and run your particular numbers.

 

Toggling between the two options will show you the results of both strategies. You’ll quickly see that tackling the higher rate is clearly the way to go.

 

But if you’re not getting anywhere with that clear-eyed approach, then looking at balances more closely may create the momentum you need to trim the remaining debt.

 

It all depends on just what motivates you.

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