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Courtesy of Wixx and our sister site <a href="http://www.debtreduction101.com">Debt Reduction 101</a>
You have probably heard the tried and true theory that the quickest way to pay off debt is to pay the highest interest bills first. There does come a time, however, when it is feasible to pay off smaller bills first - particularly certain credit cards with high minimum payments. For example let's suppose that Johnny has been building credit card debt on four separate accounts and now has the following accounts. Leaving aside the option to transfer funds from his higher interest cards to the lowest, for another article when I can devote more time to that particular topic, let us examine the possibility of reducing Johnny's debt.
<center> <table bordercolor="#336699" cellspacing="0" cellpadding="4" width="475" border="1" style="font-size:7pt"><tbody><table border><tr><th>Account</th> <th>$ Amount</th> <th>% interest</th><th>min. payment</th></tr><tr><th>A</th> <th>$3000</th> <th>16%</th><th>$60</th></tr><tr><th>B</th> <th>$2000</th> <th>15%</th><th>$40</th></tr><tr><th>C</th> <th>$300</th> <th>13%</th><th>$20</th></tr><tr><th>D</th> <th>$700</th> <th>15%</th><th>$20</th></tr></table>
</center>
Supposing that Johnny has come up with $250 a month to use for debt reduction, it would actually be better for him to pay off credit card C first and then use that extra $20 a month to help pay off card D next. This will have credit cards C and D paid off in 4 months and now he is paying off his highest interest account A with an extra $290 each month. This makes sense only because the C and D accounts have high interest themselves.
If account D was only 10% interest it would not be better to pay it ahead of A or B. The length of time required to pay off the smaller debts is very important as well. If account D had more than just a few months of reduction payments on it, the money would do more work to tackle the large A account first.
Paying off the higher interest rates is the best way pure and simple because you save interest by paying on $250 less the next month, but if you have a few small debts that can be tackled in a few months, and in particular if they have higher minimum payments, paying them off first is a great alternative.
The reason that this can be good is that it gives a sense of accomplishment. We are an instant gratification society, and even though he will save over $1000 in interest by paying off account A first, Johnny does not feel that he is accomplishing anything until he is writing one less check per month. Paying off account C so soon makes Johnny feel good that he is getting his debt under control (and thus will continue to pay down debt and not give up on the strategy). Then when he is working with that extra $20 to use on the accounts with larger dollar values attached to them, his confidence is again boosted.
Adding a car loan to this increases the complexity drastically. Auto loans are typically lower interest than credit cards, but have much higher monthly payments. These higher payments mean that paying this loan off sooner could double the amount of monthly funds that Johnny has available to knock out that credit card debt, but paying that money on the much higher interest credit cards instead reduces the interest paid over the length of the credit card repayment schedule and is the best alternative. Unless your car loan has a high interest rate, it is best to pay that extra money on credit card debt than it is to double up that car payment.
As for mortgages, the overall amount of the loan is so large, and the interest rate <i>should</i> be low enough to make this the final step of the debt reduction process, in my opinion. Once the credit card debt is paid off, the money can then be sent to pay off the mortgage quicker.
You have probably heard the tried and true theory that the quickest way to pay off debt is to pay the highest interest bills first. There does come a time, however, when it is feasible to pay off smaller bills first - particularly certain credit cards with high minimum payments. For example let's suppose that Johnny has been building credit card debt on four separate accounts and now has the following accounts. Leaving aside the option to transfer funds from his higher interest cards to the lowest, for another article when I can devote more time to that particular topic, let us examine the possibility of reducing Johnny's debt.
<center> <table bordercolor="#336699" cellspacing="0" cellpadding="4" width="475" border="1" style="font-size:7pt"><tbody><table border><tr><th>Account</th> <th>$ Amount</th> <th>% interest</th><th>min. payment</th></tr><tr><th>A</th> <th>$3000</th> <th>16%</th><th>$60</th></tr><tr><th>B</th> <th>$2000</th> <th>15%</th><th>$40</th></tr><tr><th>C</th> <th>$300</th> <th>13%</th><th>$20</th></tr><tr><th>D</th> <th>$700</th> <th>15%</th><th>$20</th></tr></table>
</center>
Supposing that Johnny has come up with $250 a month to use for debt reduction, it would actually be better for him to pay off credit card C first and then use that extra $20 a month to help pay off card D next. This will have credit cards C and D paid off in 4 months and now he is paying off his highest interest account A with an extra $290 each month. This makes sense only because the C and D accounts have high interest themselves.
If account D was only 10% interest it would not be better to pay it ahead of A or B. The length of time required to pay off the smaller debts is very important as well. If account D had more than just a few months of reduction payments on it, the money would do more work to tackle the large A account first.
Paying off the higher interest rates is the best way pure and simple because you save interest by paying on $250 less the next month, but if you have a few small debts that can be tackled in a few months, and in particular if they have higher minimum payments, paying them off first is a great alternative.
The reason that this can be good is that it gives a sense of accomplishment. We are an instant gratification society, and even though he will save over $1000 in interest by paying off account A first, Johnny does not feel that he is accomplishing anything until he is writing one less check per month. Paying off account C so soon makes Johnny feel good that he is getting his debt under control (and thus will continue to pay down debt and not give up on the strategy). Then when he is working with that extra $20 to use on the accounts with larger dollar values attached to them, his confidence is again boosted.
Adding a car loan to this increases the complexity drastically. Auto loans are typically lower interest than credit cards, but have much higher monthly payments. These higher payments mean that paying this loan off sooner could double the amount of monthly funds that Johnny has available to knock out that credit card debt, but paying that money on the much higher interest credit cards instead reduces the interest paid over the length of the credit card repayment schedule and is the best alternative. Unless your car loan has a high interest rate, it is best to pay that extra money on credit card debt than it is to double up that car payment.
As for mortgages, the overall amount of the loan is so large, and the interest rate <i>should</i> be low enough to make this the final step of the debt reduction process, in my opinion. Once the credit card debt is paid off, the money can then be sent to pay off the mortgage quicker.
The three options for debt reduction seem to be:
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