How to Pay Off Debt
Most financial “experts” have an opinion on what method consumers should use to pay off debt. These solutions assume you have a small amount of dispensable income left after making the minimum payment or standard loan payment that you can and WILL to apply toward your debt. If your cash flow only allows you to pay the standard payments on your debt you’ll need to look at other options such as a consolidation loan, equity line of credit, or (if feasible for collateralized loans) a total refinance. The two most common philosophical views on how to pay off debt are paying the highest interest debt first or paying the lowest balance first. First I’ll review those methods and then offer a few additional tips or warnings that will help you pay off debt.
Higher Interest First
Traditionally, consumers with multiple interest bearing credit cards or loans have been urged to pay off debt in order of the highest interest rate first. The upside is that mathematically over time the consumer is left with lower interest rates on their remaining debt therefore pay less interest over the life of the debt(s). From this perspective, this method is totally sound and is indisputable, however many times, particularly with credit cards, the interest rates are so close that the amount of interest saved over a short span of time (say less than 2 years) is inconsequential. The insignificance of the interest savings allows consumers to look at differing methods to pay off debt such as the Snowball method below.
Lowest Balance First (Commonly referred to as the Snowball Method)
Dave Ramsey has made this method famous via his radio show and books, namely The Total Money Makeover. In short it calls for the consumer to pay only the minimum payment on all balances except the debt with the lowest balance which you then pay as much as you possibly can each month until you pay off this debt. At this point you attack the next lowest balance with a fury, then the next, and the next, and so on until all debt is extinguished. The upside to this method is that you’ll get a psychological payoff faster with the lowest balance freeing up not only your extra payment but the minimum payment previously associated with that debt as well. While the traditional method of paying off the highest interest rate first is mathematically sound, the likelihood that the various interest rates differ significantly enough to make a substantial difference is very low.
For example, I randomly created 5 credit card balances with varying interest rates and minimum payments totaling $115 and assumed I had an additional $35 per month (total of $150) in order to make payments on the debts. Paying the higher interest rate first saved over 36% of the total interest that would be paid if only the minimum payments were made. However, that method saved just $3.59 (less than 1% of the total interest paid) in interest over the Snowball method (lowest balance first). Certainly, different variations of balances, interest rates, and available cash flow will generate slightly different results but the premise remains that excess interest paid using the lower balance method rather than the higher interest method will be minimal.
The traditionalist view to pay off debt in order of the higher interest rate will ultimately be the most economically sound as it will result in your paying out the least interest over the life of the debt while the snowball method offers some psychological and cash flow advantages without significant interest losses. However, neither accounts for all factors present in today’s environment. For instance, many credit cards now charge a monthly or annual fee which is sometimes as much as $7-$10 per month. So you are not only paying excessive interest rates in most cases, but as much as $120 per year for the privilege of doing business with the bank. Without going off on a rant as to the ethics of banks that charge these fees, the practical impact of these fees is negating a portion of your payment if you carry a balance and maintaining a monthly obligation if your balance is zero. You are the customer, don’t let this bank mooch off you without providing a good or service in return.
A Few Tips to Help you Pay off Debt
- Make choices that help you. An example, pay off debt that frees up your money for other uses; let’s say you owe $300 on a card with a $15 minimum payment and $320 on a card with a $25 minimum payment. I would pay off the latter card first to free up more cash flow, more quickly.
- Commit to your plan, it may not be the best plan for everyone, but once you have a course of action execution is the most difficult task.
- Once a card with a monthly fee has a zero balance, deactivate the card. There is absolutely no benefit to you to pay the bank for the privilege of carrying their card in your wallet.
- Don’t jump back and forth, that’s the fastest way to lose momentum.
- Try not to continue spending on your credit cards, but if you have to; under no circumstances should you continue using the card you’re currently trying to pay off.
- If it needs to be said, do not allow yourself to get back into bad habits once you pay off debt. Build savings and pay for things in cash.
I’m mostly looking at this using credit card debt as an example, but it applies to any unsecured debt or collateralized loan for a depreciable asset, basically anything other than your house. It is for this reason I have used the term minimum payment, but for a loan the same concepts apply to your standard monthly payments. I echo my own personal finance mantra that seems to underlie all my articles, know how things work, make a plan, and execute. Even if you make some mistakes along the way you’ll be better off than the guy (or lady) still making minimum payments.
Please send any questions or comments to Jeremy Woods.