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Should You Pay More to Smallest Amount Debt Or High Interest Debt First?

Thursday, April 1st, 2010

In your efforts to get rid of debt as soon as possible, you pay more toward to your debt when you have extra money. On every extra dollar you make, you will save in total interest and shorten the time you get rid of it significantly. The question is which debt should you pay first with the extra dollars you have?

There is no right or wrong answer; it depends on what you want. Most debt relief guides will go for the approach of paying the highest interest-rate debt first. In fact, this is a better approach because it will save more money and helps you to get rid of it faster. But, psychologically it is a more stressful approach as you will feel that there is no movement in reducing your debt during the process of paying it because all debts still remain. On the other hand, if you choose to pay off debt with smallest amount first, then psychologically you will feel that you are getting rid of them one by one. So, whether you should pay more toward smallest amount debt or focus on paying the highest interest-rate debt depends on your choice. However, let’s explore each approach by example so that you have better picture on which approach suit you better.

Case Scenario:

Jack Brandon makes $60,000 annual income yearly ($5,000 monthly) and he has three loans: $6,000 at 3.85%, $12,000 at 8% and $40,000 at 4.50%. He likes to focus on one loan at a time by paying more toward it while paying other with the minimum payment. 30% of his monthly income will be used to pay the loan so that he can get rid of debt faster.

Assumed that the repayment period of each debt was for 10 years, the Jack’s minimum payments are:

a. Minimum payment for $6,000 debt at 3.85% is $60.32

b. Minimum payment for $12,000 debt at 8% is $145.59

c. Minimum payment for $40,000 debt at 4.5% is $414.55

The total monthly minimum payment for Jack is: $60.32 + $145.59 + $480.04 = $620.46

Since Jack plans to use 30% of his income to pay for his debt, he has $1,500 to be used for this purpose.

Let’s explore each approach with the scenario:

1. Pay more toward smallest amount first

Using this payment method, Jack will focus on paying extra dollars to the smallest debt while making only the minimum payments for the rest. After get rid of $6,000 debt, he works on $12,000 and finally on $40,000 debt. With this approach, Jack takes 7 months to clear $6,000, 19 months to clear $12,000 and 45 months to payoff $40,000.

Jack will take 45 months to clear off the 3 loans and pay a total of $5456 on interest.

2. Pay more toward highest interest-rate debt first

Using this payment method, Jack will focus on $12,000 loan first because it has the highest interest among three. He makes extra payment to the highest interest-rate loan while making only the minimum payment for the rest. With this approach, Jack takes 13 months to clear $12,000, 40 months to pay off $40,000 and 43 months to clear the $6,000 loan.

In this case, Jack will need to use 43 months to get rid of his debt with a total of $5021 on interest.

In summary, although the second method helps to get rid of debt faster with less interest, the first method that use to pay the smallest debt first is more encouraging as you will see one of the loans, the $6,000 loan is paid off after 7 months and left with only 2 loans to focus on and after 19 months, you left only one loan to be cleared; comparing the second method which focuses the payment on the highest interest rate debt first, Jack will only see his debt to start get rid of after 13 months and need to wait until the 40th months to totally get rid of second loan. Now you have a better idea on both methods of debt payment, you choose your preferred method to get rid of your debt.

How to Pay Off Your Debt Faster With Less Interest

Friday, March 26th, 2010

Debt needs to be paid off, you have no other option, but you can choose the way to pay it off. If you have a certain amount of money to pay off a portion of your debt each month, you can choose to allocate any extra cash on the highest interest rate debt or the highest amount debt. Both serve the same purpose of paying off your debt, but which one is better? If I were you, I would choose the method that can help to pay off my debt faster and with less total interest.

In fact, there is an approach that can help you pay off your debt faster and with less interest. This approach is called Debt Avalanche. By paying your debt using debt avalanche approach, you will pay off your debt faster and pay less total interest to your creditors. How it work?

To use the debt avalanche approach, what you need is a list of interest rate of all your debts. Let make it simple by assuming all debts have the same tax liability, but if you want to compile for your debts that have different tax liability, then you need to determine the debts’ interest rate after taxes. You will need these interest rates for calculation in debt avalanche approach. Below are the steps involve in the compilation and calculation on which debt to pay more in debt avalanche approach so that you save money in term of interest and be debt free faster:

Step 1: Order your debts with highest interest rate to lowest.

List your debts on a paper (or spreadsheet if you use software) according to the interest rates, sort them from the highest interest rate to the lowest. Normally, credit cards will be ranked higher as typically credit card interest is 10% to 20% or more. Then, personal loans may be your next highest interest rate loan followed by auto loan, mortgage and home equity loan. Don’t border about the balance of each debt, it will not be used in this debt avalanche approach.

Step 2: Pay minimum due on each debt

Then, add a column on your list or spreadsheet for the minimum amount need to be paid each month. This is the amount you need to pay toward each debt, except the one on the top list. Then, compile the list for the total minimum amount that you need to pay for that month.

Step 3: Pay extra cash toward the debt at the top list

In order for the debt avalanche approach to work, the money you prepare to pay your monthly debt should have a bigger amount than the total minimum month due for all your debts. Pay only the minimum due for all your debt except for the top listed debt which has the highest interest rate. Allocate the extra cash (the money you allocate for your debt minus the minimum monthly due on each debt) to this highest interest rate’s debt, the top one on your list.

Step 4: Repeat every month

By paying the minimum due each month, you are meeting the payment requirement of every creditor. And at the same time, you hone in on only your debt with the highest interest rate. Repeat step 1 to step 3 every month, you need to re-order your list if your debt interest rate has changed. Remove from the list if the debt had been paid off (it might not be the debt on the top list if other amount is smaller).

If you record your payment each month, you will notice a significant amount save in term of interest and the time frame to pay off your debt is shorter. You can do a simulation in spreadsheet software if you want to know how effective the debt avalanche approach helps in paying off your debt faster and save in total interest.

Summary

Debt avalanche approach is mathematically the best method for paying off your debts. It helps to get rid your debt faster with less total interest.

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