Try Taking A Different Approach to Paying Down Debt
There are generally two schools of thought when it comes to paying down debt: pay off the highest balances first and pay off the balances with the highest interest rates first. But neither of these methods addresses the true issue on their own, which is minimizing interest payments in order to pay down the principal balances more quickly and eliminate the debt.
Looking at the situation strictly from a balance standpoint or an interest rate standpoint does not tell the whole story. If you have several debt obligations, you will be better served to look at the interest being charged on your statement for a more accurate view of your situation. The interest you pay should be the determining factor in which obligations get paid first. Take the following rough examples of debt obligations:
Principal balance of $10,000 interest rate of 1%
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Principal balance of $6,000 interest rate of 10%
Principal balance of $2,000 interest rate of 16%
Assuming either of the more common debt-reduction methods were used, some people would pay the highest balance or the highest interest rate first. However, while those methods would work toward paying down some of the debt, the second obligation, although significantly lower in dollar value than the highest obligation and lower in interest rate than the highest value would end up costing the most
in interest during that time. That is why you need to take a different approach and analyze each of your debt obligations to see which is costing you the most in interest, which in turn will lead to a longer amount of time and resources to eliminate, especially if you are only paying the minimum required payment.
The issue gets even more complicated if you are looking at interest rates alone, specifically on credit cards, because many times there purchases with different interest rates attached on the same card. In addition, as time goes on the rates on a particular can fluctuate so as to increase or even decrease after your debt-reduction plan has begun. That makes the strategy of looking at interest summary even more important. It looks at the bottom line figure of how much interest you are paying on each obligation as a whole.
It may involve a bit more work than simply saying “I will pay off the highest balances first” or “I will pay the balances with the highest interest rates first”, but in the end you will save quite a bit of money in interest charges, and even more time since the interest will not compound and continually increase the balances owed as quickly. You may need to re-evaluate your strategy every few months or so just to make sure that your payments are having the most positive impact on your debt situation, but it wil certainly be worth it once you start to see a noticeable change in your situation.
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December 17th, 2008 at 10:21 pm
Time taken to work out the best combination of savings, is time well spent.
December 17th, 2008 at 11:05 pm
Personally, I would agree Andy. Unfortunately some people are prone to take the simple route which is a shame.
December 19th, 2008 at 3:26 pm
Good post. I’m not good with rigid instructions so I constantly tinker with the “formula” for fun and to see what works best.
I found a good site where you can fiddle with what order you want to pay things so I do my calcs there to see any real difference in how I chose to do it.
December 19th, 2008 at 4:11 pm
The most important thing is to find what works for you. Rigidity is only good if you are locked in on a goal, and even then having some flexibility would probably be more beneficial.
January 21st, 2009 at 12:23 pm
I am debt free and I’ve never had consumer debt. But…
If I had the debts above and didn’t have enough money to just send a check to b) and c), I’d:
a) Forget about emotion and concentrate on the bottom line.
b) keep 1% loan around for as long as possible even if I had money to pay it off, unless 1% period expires soon. Even if I have money, with 1% rate, I can simply pay the minimum and make extra “payments” to a high-yield saving and money market, then – as 1% period gets closer to expiration, I’d take the money from this saving account and send them one large check. Then see where I am at. If there is balance left – get another low interest offer, transfer remaining balance and repeat.
In fact, if someone wants to lend me money at 1%, I’ll take it. I don’t need the money, not with my almost-seven-digit net worth, but I’ll take it… I can get tax free 3% on short term AAA municipal bonds and tax free too. OK, this may carry some risk but taxable 2.8% on savings is still better than 1%.
b) Get 0% card and transfer remaining balances there. Then do a).
If 0% offers aren’t available, I’d agree with you. If someone got into credit card debt in the first place and it wasn’t because of medical emergency, then the first thing they need to learn to do is to forget about emotions and learn to look at the bottom line. I have a friend by the way who did exactly this – shuffle debt from one 0% offer to another while keeping extra money on high yield saving and short term CDs – when she was faced with non covered medical expenses. She comfortably repaid it. BTW – she is a millionaire now.
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