Personal Finances

Create a Plan to Get Out of Debt

If you set a priority of being out debt by a certain date, you will need to determine how much you must pay each month until date to reduce you debt payments to a manageable percentage of your take-home pay.

Figuring how much to pay toward your debt each month

If you set a priority of being out of debt by a certain date, you will need to determine how much you must pay each month until that date to reduce your debt payments to a manageable percentage of your take-home pay. This is particularly important if you have a lot of installment credit or credit card debt. To calculate this amount, you will need a financial calculator. You can find free financial calculators on many websites or in financial software you may already own. In the following paragraphs are the basics to determine how much you should be paying each month to eliminate your debt by your target date:

Determine how much to pay toward your debt each month. Determine an interest rate to use. Pay off the high-interest-rate loans faster than the lower-rate loans.

Determine the amount of debt and the interest rate to use

Determine how much debt you want to eliminate by the target date—this is the principal (P). For example, suppose you have several credit cards totaling $10,000 and a student loan balance of $10,000. If you only want to pay off all the credit cards and half the student loan in three years (you feel you can manage the rest of the student loan later), your principal will be $15,000.

Determine an interest rate to use. The highest rate from all your loans might be the best one to use, as it will help you calculate your way out of debt faster. Let’s say that you have one credit card balance with $7,000 at 15%, another with $3,000 at 7%, and the student loan ($10,000) at 3%. Choosing 15% as the rate (R) will help you calculate payments to most quickly reduce your debt. Of course, you could use a weighted average, but we will leave that for a mathematics textbook to explain.

Set the term (N) as the number of months or years to achieve your goal. In our example, we are using three years, or 36 months.

The result

When you plug these numbers into a financial calculator, you will come up with a monthly payment (PMT) equal to approximately $520. This is the number you should use to get out of debt in the time you set as a goal. All you need to do now is to allocate how much of the payment should go toward each of the loans you are paying off. The best way to allocate the payment is to pay off the highest-interest-rate loans faster than the lower-rate loans. In our example, we might allocate the largest amount to the 15% credit card, with lower amounts to the others.

If your calculated payment is still more than you can afford, you may need to consider refinancing methods. However, if this works for you, you could choose to make those larger monthly payments to your savings and investment plans after your debt is gone?

Disclosures