Thursday, December 24, 2009

Baby Step 2: Pay off your Debts

Now that you have the baby emergency fund in place, and have committed to stop spending using credit cards, it’s time to start paying off your debts.

To accomplish Baby Step 2, tear off another sheet of yellow paper and list your debts excluding the house. The order that you list the debts is important. You want to write them down based on the amount owed (smallest to largest) and not based on the interest percentage.

It’s Not Mathematical

Earlier, I think I alluded to the fact that I really do not mathematically trust myself – I unapologetically will use a calculator to accomplish very simple task. However, I do know that the longer you take to pay of something the more you will pay because of the interest.

Shouldn’t the mathematically correct order be based on the interest rate?

It would be if we were concerned with the math, which, honestly, we are not. We are concerned with behavior. When you reinforce good behavior with immediate results something happens – you begin to believe that this stuff is going to work.

And, once you believe, brother, trust me, you start having a new kind of hope with your finances.

It’s a Snowball

We want to target the smallest debt to try and get a quick win and give you some positive traction. Pick up your debt list and add a column called Minimum Amount and fill in what the debtors indicate is the minimum amount that you need to pay.

While paying off your debts, you are going to pay the minimum amount on all of your debts with the exception of the smallest debt.

The smallest debt, you are going LOOK for extra money in your budget (now that it is listening to you) and add that to your smallest payment. Here is the mental picture – you want to get laser focused on paying off that smallest debt and knock it off.

Once the smallest debt is paid off, you are going to take the amount you were previously paying on the first debt and then apply that to the second debt.

Each time you pay off a debt, the amount of money that you have to pay the next debt off increases. It’s like building a snowman – you start with a tiny snowball, but every time it flips over it grows bigger and bigger.

And this stuff works!

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