Which Debts to Pay Off?

One of my clients who bought a home a few years ago contacted me wanting advice on which debts they should pay off now that they have received a bonus.  I welcome opportunities like this!   Their priorities are to:
  1. Eliminate debt while
  2. Maximizing their credit scores
Here are the debts:
  • Credit Union (motorcycle) – $5000.00 @ $185.00 per month (see #1 below)
  • Bank – $2115.83 @ $37.21 per month (see #9 below)
  • Bank – $5010.65 @ $165.00 per month (see #10 below)
  • Credit Card – $2278.74 @ $66.00 per month (see #7 below)
  • Credit Card – $1937.22 @ $44.00 per month (see #8)
  • Bank – $877.45 @ $15.68 per month (see #6 below)
  • Bank – $870.92 @ $27.00 per month (see #5 below)

They have received a bonus in the amount of $8,600 and expect a income tax return in the amount of $4,500.   They may eventually sell the motorcycle for around $4,000.   And…in May it sounds like they will be receiving a check compliments of the Economic Stimulus Package (they can put that in their rainy day fund).

If their goals are to stay in their current home and just get rid of this debt, here is what I would recommend for a strategy:

  1. Pay off the bike.   This leaves $1600 of the bonus and free’s $185 per month.
  2. Put the $1600 into a savings account that they don’t touch.  This is the beginning of their emergency fund (which they currently don’t have).
  3. Put the bike up for sale.  Until it does…
  4. Put 10% of your gross income into your emergency fund…pay yourself first (before you go out to dinners, movies, etc.)…can’t do 10%, get in the habit of doing 5%.   You should have an emergency fund of no less than 3 months of your mortgage payment (for your first goal).
  5. Pay $185 (that was once paid towards the bike) plus the $27 all ready paid towards the bottom debt for $870 for a total of $212.  This debt will gone in just 4-5 months!  YEAH.   Cut up this card, close this account.  Ya don’t need it.
  6. Now you can apply $212 plus $15 for a total of $227 towards the next small debt and this will be gone in 4-5 months.  You don’t need this debt either…close it.
  7. You probably have your tax refund now of $4500.  Pay off the credit card for $2278 and put the remaining $1800 into your emergency fund.   NOTE:  You now have $3400 in an emergency fund plus your monthly contributions!  And you have also eliminated $293 per month in debt!  CONGRATULATIONS…
  8. Has the bike sold?  If so, pay off credit card with balance of $1937 for $44 per month.  Now you’re saving $337 per month to apply towards the debts.   Go ahead and put the difference between the credit card debt pay off and the bike proceeds into your emergency account.   YOU’VE ELIMINATED 5 DEBTS!
  9. Now take the $337 you’re saving plus the $37 you’re all ready paying = applying $374 towards bank debt in the amount of $2115 per month.  This debt should be gone in roughly 6 months.
  10. Take $374 plus $165 (that you’re all ready paying) and apply $539 towards your last debt in the amount of $5010…this one will be gone in 9 months!

Did this take a while to accomplish?  Yes.  Did it take you a while to create your debts?  Yes.  I think it’s easier to approach debts if you hit them one at a time starting with the smallest debt that has the largest payment.   You’ll feel rewarded as you accomplish paying debt after debt off.   

For the purposes of having a good credit score, you’ll want to maintain 3 accounts in addition to your mortgage.  The older the account is (in good standing) the more weight it carries with the credit scoring system.  If you have a car payment and a mortgage, pick two credit cards that are older with the best terms and keep them open with balances below 30% of the credit limit.  Close and chop up the others.

Now you can invest the $500 a month you were spending on debt into your retirement accounts or maybe start a 529 account for your children.

Good luck!

NOTE:  This strategy is specifically designed for one of my clients.  This may or may not work for you depending on what your goals and needs are.  Restructuring debt by refinancing is also an option if the home owner qualifies and their is enough home equity to do so. Please consult with your Mortgage Professional and financial advisors.

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