The Debt Reduction Plan

Overview of Debt Reduction

Remember that we had the client list the minimum payments for each debt in the Spending Plan? Y0u may have wondered why not pay more than the minimum on the credit cards. The debt reduction plan does exactly that, but targets one card at a time. Separating the Extra debt repayment from the minimum payments helps manage the debt reduction plan.

The basic strategy of the debt reduction plan is to pay off the smallest balances first, one at a time. You might think that it would make more sense to pay off the highest interest rates first. However, experience shows that the psychological value of getting some wins sooner rather than later far outweighs the somewhat nominal gain related to interest rates.

Getting Started

Start by having the client list their minimum payments in the Spending Plan. Then, through the process of adjusting the Spending Plan and finding expenses to reduce or eliminate, have the client identify an amount that they can add for accelerating debt repayment. Emphasize that the more they accelerate the payment, the sooner they will be out of debt. This usually calls for some sacrifices in the short-term in order to realize the benefits of being debt-free for the long term. As we’ve noted earlier, most of these sacrifices will come from the Household/Personal and Entertainment category groups initially.

For example, suppose that your client can reduce monthly eating out expenses from $250 to $150, clothing allowance from $200 to $150, and eliminate $50/month for movies.  This would total $200/month that can be allocated to debt retirement.  Have the client record this $200 in the “Extra debt retirement” item under Debt Payments. This is the amount the client has to work with to accelerate debt repayment on the first debt.

Creating the Plan

Note: this section refers to the sample Debt Reduction Plan attached to the Materials tab of this topic.  If you haven’t already downloaded and printed that document, please do so now.

Here’s how the Debt Reduction Plan is created:

• First, list all the creditors and the amount owed to each in the first two columns. List these in order of lowest balance owed to highest balance owed. Include all debts except for mortgage.
• In columns 3 and 4, list the interest rate and the minimum payment for each debt.
• Write the “Extra Debt Retirement” amount in the “Additional Payment” space. This amount will remain the same throughout the debt retirement process and will be applied to each debt in turn as the previous debt is retired.
• Beginning with the fifth column, indicate the total amount paid (including the additional payment) monthly on each debt.
• Total the “Amount Owed,” Minimum Monthly Payment,”  and “Additional Payment” columns and write the results in the “Total” row.

Working the Plan

In the sample Debt Reduction Plan, note that the initial monthly payment on the Sears card is the minimum ($15) plus the additional payment ($150), for a total of $165. At that rate, the Sears card will be paid off in the third month.

Once the Sears card is paid off, the entire Sears payment ($165) is rolled into the Doctor payment. Adding this to the minimum $20 Doctor payment, this payment is now $185/month until paid off.

When the Doctor is paid off, that entire payment ($185) is rolled into the Visa payment, which now increases from $40/month to $225 per month until paid off.  This process continues until all the debts are paid off.

The calculations involved to project the dates on which each debt will be paid off are a bit complex; note that it’s not necessary to know these dates at the beginning. The Debt Reduction Plan can still be created without the dates – the important thing is to keep rolling the debt payments into the next debt until they’re all paid off. Note that throughout the plan, the total debt payments remain the same – $534 in the example.

Activity: Creating a Debt Reduction Plan

Open the workbook you downloaded at the introduction to the course.