A (Slightly) Different Approach To Pay Off Debt
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Are you in debt?
Have you been in the past?
Yes?
Than you’ve probably researched the hell out of “ways to get out of debt”.
Probably to the point of being sick of seeing those words!
And I bet you discovered this annoying fact…
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.
What issue is that?
Minimizing compounding interest charges.
Why is that the big issue?
In order to pay off your debt, your payments need to reduce the principal.
If you are continuously incurring interest charges, your payments reduce less of the original principal balance with each cycle.
And that’s if you even make the minimum payments each month!
If you can’t even do that, then you’re really getting buried by the compounding interest charges.
A Combined Approach To Paying Off Debt
That’s why I prefer to combine the two theories into one comprehensive method that reduces the debt while also minimizing the amount of interest that will be added along the way.
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 loan or credit card statement for a more accurate view of your situation.
Don’t just look at the interest rate, because that can be misleading.
Instead, look at the total interest you pay as that 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%
- 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 are purchases with different interest rates attached on the same card.
In addition, as time goes on the rate on a particular card 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.
This way, you are seeing the total impact of the outstanding debt plus the applicable interest rate being charged on those outstanding balances, not just the balance or rate on their own.
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 will certainly be worth it once you start to see a noticeable change in your situation.
I would definitely address the one with the highest interest rate first. Eventually the money I will save on interest can go towards the other debt. Interesting post. I am sure you go some people thinking.
I really don’t care if people agree or disagree with anything I say on any topic, but my real validation is the last thing you said. If I can just get people to consider different angles or think about what they do a little differently, then I’m happy.
I like to target the higher rates as a general rule. If you must carry a balance the interest really slows down the repayment, and fees are also a major consideration. Before targeting repayment options, you really need to change spending behavior by reducing outflows. I like the way you presented this!
Thanks Hunter. I completely agree that a change in attitude needs to be one of the first steps. Otherwise, it’s just the same repetitive cycle.
This makes SO much sense. I wonder why I never even thought about it this way. Paying debt strictly based on whole numbers can cause you to lose more money over time, which is the complete opposite of what you’re trying to accomplish. This is excellent advice!
Taking all the factors into consideration, interest rate, balance and the best method that works for you while trying to manage money is very important.
Thanks Carrie! I understand that some people need to satisfy their psychological issues when it comes to money and debt, but I’d hate to see people feel successful for paying off a small balance when a larger debt may be causing them to incur more interest charges than the debt that was paid off had in principal.
Although it is good to look at things with fresh eyes, I’m a big proponet of the KISS principle. I don’t know that I would take the time to figure out the actual dollars in interest per period (for each period) I would be paying – if I had any debt (which I don’t), I would pay down the highest rate balance first.
I’m like you on this one Marie. Keep it simple and just go for it. I’d pick the highest interest rate, but if someone wants to pick the smallest balance, that’s fine too, Just pick one and do it.
Oh no, I didn’t mean to reassess the situation with each set of bills, that would be way too much work. Generally, using this this technique would keep the debts in the same order for quite some time, but it would be wise to recheck after a few months. Unfortunately, this way the psychological effect of removing a debt completely most likely won’t be reached in a short amount of time, but the savings it would yield are much larger than either method on its own
Oh no, I didn’t mean to reassess the situation with each set of bills, that would be way too much work. Generally, using this this technique would keep the debts in the same order for quite some time, but it would be wise to recheck after a few months. Unfortunately, this way the psychological effect of removing a debt completely most likely won’t be reached in a short amount of time, but the savings it would yield are much larger than either method on its own
I usually like to pay off those that are the highest first and then work down. But it depends whether their interest rates are high too. I’m no math geek so I usually go for the ones which, I think, could affect my savings more than the others.
I’m all for any course of action that will help people actually reduce their debt. The problem in my mind is that if the interest from the previous month makes up most of the current minimum, then there is no real gains being made. And it’s as simple as looking at the statement to see which one has the highest finance charge added in the previous month.
personally I don’t to pay any interest so, I pay down my CC balance every month and don’t think of interest. I bought my first car with down payment and second one with 0% Toyota financing. And I don’t have mortgage yet, hence I am debt free for now.
One advice try calling your debtor multiple times to lower interest rate on debt or by other means like refinance etc. At least I know people successfully reduced interest on mortgage, car loan and CC debt.
Getting the interest reduced would be helpful. The problem there, is that a reduction will only speed up the process so much and many times, people won’t qualify for any kind of refinancing of the debt. Even if it is reduced, it won’t ever be eliminated so, a pay-down plan still needs to be enacted.
Something I just thought about and mentioned below as well: it’s really not much work to find out which debts are costing you the most in interest. All that needs to be done is to look at the statement for the current activity and the finance charges are right there. This way, after the minimums are paid, (in my view) the debt that has the highest finance charge should get the extra money applied toward it since it is costing the most to carry.
I used the pay down the smallest balance first. I know it may have (could still be) costing me a bit more money, but it didnt matter. I had tried too many other things using the other ways that plain old didnt work, and I figured this would work, and it did. So, it may have cost me an extra 200, but I dont care – because it worked.
Had it not worked, i’d be out way more than 200.
If it worked then that’s all that counts. Sometimes, it’s just a matter of trying different methods to find out what works for you, even it means failing at times.
I thought it was pretty common to approach by paying the *smallest* balances first (the debt snowball a la Dave Ramsey). I would always pay the highest interest rate first. If I have $100 to pay towards debt, the $100 will have a bigger interest-saving impact on the balance with the highest effective interest rate. Another factor would be terms of repayment. If my mortgage is $600 and my credit card is $100, if I only have $600 to pay towards debt one month, it would have to go to the mortgage (although if you paid only $500 on the mortgage and then paid off the card, it’s not like they’re going to foreclose on you immediately for missing part of your payment.)
I really don’t think it matters very much how someone would go about it, but the important thing is that the debt gets paid down. I’d always choose the mortgage before the credit card, not just for tax purposes, but also because credit cards are revolving and can be paid off over time, and you don’t want to do anything to get on the bad side of the mortgage company.
I always attacked the highest interest first when I had debt, and left the student loans for last.
I love how low my interest payments are now on my mortgage. I am in the process of refinancing my rate which I thought could never be beat at 4 3/4. Doing a refi down to 3!
Don’t be mad, but I hate you! I’m stuck at at 6.875 and my place has been devalued to the point of being impossible to refi.
It makes a lot of sense to pay student loans last since they generally have much lower interest rates than consumer debt. And, it’s the only debt which is deductible so it makes sense to use free cash to pay off other debts first.