Clearing debt - is there a right way?

Having built up a reasonable amount of debt, we figured that our road to financial independence better start with clearing some of it down. Fortunately, we're in the position where our liquid assets (share options, primarily - see here) surpass our current level of debt. Now this probably means how we clear the debt doesn't really matter, but we found it a useful thought exercise to think through some of the ramifications and theories around paying down debt.

Let's start with the kind of debts we have as precursor to how we might go about clearing them:

We'd suggest putting together a little spreadsheet, one line per element of debt (split out your cards if they have different interest rates for different things), so you have a full picture before you start thinking about where to offload any excess cash. Once you have that, we can start to think about the right way to pay it down. There are a bunch of theories around the best way to clear debt - we're going to bucket them into two broad camps which we'll categorise under the headings minimisation and motivation. Let's take a look at each.

Minimisation

Dumb name for a category, right? Well, bear with us, and we'll explain. What we mean here is that this form of debt clearance minimises your financial exposure, meaning you pay the least amount out over the lifetime of your debts. In a nutshell, that means ranking your debt by the combination of the interest rate and the penalty you incur for clearing them down. THis would give you a hitlist of debt which - if you clear it from top to bottom - would mean that you pay the least amount of interest. Overall, that means your money works harder for you - less of each pound goes to servicing interest payments, which means more of it can go toward clearing debt, building savings, funding investments, or buying pointless niceties (your choice, obviously).

Sounds simple, and clearly the right thing to do, no? Clear the most expensive debt first and your money goes further and you reach financial independence quicker. No brainer. Well, that's true, if we were machines and didn't have the failings of human nature to deal with. This is where camp 2 - motivation - comes into play.

Motivation

This alternative way of clearing persistent debt is as much about the human side of how we handle money as it is the financial side. Inevitably, paying off debt may not be the most inspiring of things to be spending our hard earned cash on. If you're laden with a lot of it, simply working from the top to the bottom in order of interest rate can feel like a grind, with little light at the end of the tunnel. Cue an alternative where we prioritise little wins in order to motivate ourselves. If you have a lot of debt, scattered across different mediums (a few credit cards, loans, etc), then lets rank them by size of the debt; smallest to largest. Ignore the interest rates, but not the penalties - treat them as part of the size of the debt.

What does that give us? A hitlist in increasing order of difficulty (i.e. how much money you need to stump up to clear that particular debt entirely). If you start at the top of this list and tick things off one at a time, you'll maybe get to your first milestone much quicker. That might mean you can close an account or cut up a credit card.

But surely that mans overall you'll pay more to service the various levels of interest? Yes it does. It's about gaining momentum and seeing progress - if you have a big, expensive credit-card debt that's going to take you months to clear, then depending on your personality it's may be much harder to motivate yourself to keep squirreling that extra bit of surplus cash away towards clearing it down. Wheareas, if you can clear a smaller (albeit less 'expensive') debt within a month, boom! Progress. Next month you clear another, then you build yourself up to taking a couple of months to clear the one after. All the time you're getting into a better habit of clearing debt rather than spending the surplus funds. Psychologically, the small wins motiviate you to keep going and reach the next goal, rather than being overwhelmed by the size if the task ahead.

So, which do we use?

That's a personal decision, and comes down to your own ability to motivate yourself and stick at a task. If you're wholly focussed on clearing debt, then minimising your interst exposure is the best way to do it - you'll 'waste' less and ultimately clear the debt faster. If you;re at all worried that you may not have the fortitude to stick with it, and might be tempted to 'just spend that little bit of spare cash on a treat', then going with the motivational approach is likely to help you see progress faster and thus, ultimately, give you a better shot of achieving the goal.

Fortunately, with the exception of our mortgage debt, which is a large amount, but pretty low interest (relatively speaking), our liquid assets exceed the level of debt we need to clear. As a result, it makes sense to just pay down the entier amount in one fell swoop; free ourselves from the burden of interest payments; and focus all our future surplus funding on the mortgage debt.