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Money Transferred to Debt

This article was written by in Debt Reduction. 12 comments.


Over the weekend, I decided to use $2,000 of the money I made from freelance web consulting last year to speed up paying off my car loan. Even though my car loan has a lower interest rate (2%) than my some of student loans (~4%), it’s more important for me to reduce the car loan. It’s not a logical choice, as keeping the money in savings was generating interest of about 4%, but some debt is more important than other debt or savings for non-financial reasons.

While financial calculators often suggest the “snowball” method for paying down debt, it’s not a one-size-fits-all solution. If all things are equal — for example, all of your debt is from financial institutions like credit card companies, pay down that most expensive debt (highest interest rate) first while making the minimum payments on the others. All things are rarely equal.

Updated September 28, 2007 and originally published January 23, 2006. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes, also known as Flexo, is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow Luke Landes on Twitter. View all articles by .

{ 12 comments… read them below or add one }

avatar Bill

At the end of the day, it probably won’t make a large difference which you paid down first. I probably would have gone the other way. Good debt vs. bad debt wouldn’t affect my decision-making at this point, but rather at the point of taking it on.

Of course, if we were talking about debt secured by assets, that would be a reason I would pay the debt with a lower interest rate off first.

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avatar samerwriter

When we first entered the workforce we had probably a dozen different loans for cars, school, etc..

We went through the process of organizing by interest rate, etc.. But though I used that as a guide, ultimately I paid off the ones that provided the biggest psychological boost. For example I had some student loans at low rates that were very small and some at higher rates that were much larger.

To me, the satisfaction of paying off an entire loan at a lower interest rate was well worth the small hit I took on interest. That provided great motivation for my wife and me to work even harder to pay off the others.

Of course very high rate debt should always come first. But if you have many loans with reasonably comparable rates, I’m partial to paying off the smallest ones first.

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avatar Caitlin

Sticking to a specific method is helpful if you don’t know where to start, but once you are comfortable you can make more complex choices that truly suit your own needs and create something truly unique…like you’re doing :) Makes total sense.

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avatar Jay Fleischman

Paying down the car note was a good move psychologically because now the car is “yours” rather than “theirs.” Remember that a car is one of the worst investments you can ever make; depreciation and resale vaue mean that you’re upside-down in your loan from pretty much the day you drive it out of the showroom.

As a matter of dollars and cents, it’s always a better idea to save your money and buy a 3-5 year old off-lease car from the dealer for cash; buying it from the dealer means it’s got a better warranty and most likely in better condition than a car from a used-car lot, and buying something off-lease means that the big “hit” in depreciation has already been taken.

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avatar Karthik

Flexo,

OK, maybe I’m missing something here. I completely understand your decision to pay off debt rather than sock in savings, rates be damn, but I’m a little lost as to why you chose the car loan over the student loans. Samerwriter talked about psychological boost, but my concern would be psychology would work against you – yeah, you may think “I have only one outstanding debt, so I can spend a little”.

Incidentally, some economists actually challenge the notion of always paying off your debt first before saving, arguing that many will tighten up till the debt is paid off, and then easen up and fail to be as aggressive at saving. So they actually say that for SOME people, it actually makes sense to save at lower rates even when they are paying higher rates on their debt, if their debt burden motivates them to be thrifty. Of course, like everything else, it’s each individual’s mental makeup that determines a successful formula.

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avatar Luke Landes ♦127,485 (Platinum)

It’s simple — I owe the money for the car to a family member who allowed me to borrow from him in order to pay cash. That debt takes precendence over anything else, regardless of the interest rate. Owing money to a family member is not a situation I want to be in.

The reason the purchase was done this way was because the family member insisted I pay for a new car rather than an off-lease version of the same vehicle as the new car was only slightly more expensive than the used. I needed confidence that the car purchased would be extremely reliable for its intended purpose.

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avatar Bill

Flexo said: I owe the money for the car to a family member…

Yep, that’s an excellent reason to priortize it other than by rate. There’s definitely peace of mind in doing that. You called it “not a logical choice” originally – I’d say it’s quite logical given the full circumstances.

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avatar Kim

My fiancé and I were just discussing last night about the order we were going to pay off our debts after the wedding. All of our debts are at 5.25% or 5.3% except for my Discover card, which is at 2% promotional rate for a couple more months and then it jumps to 15%. So even though it would make sense to pay the Discover first, I want to get off the books with my Dad. He loaned me $2000 for my down payment for my car a couple years ago, and I just want to have that gone (it’s down to about $1000 now). So I understand where you’re coming from when you say you don’t want to owe money to a family member.

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avatar Dave

Flexo, you should have mentioned it was family debt in your post! Otherwise your post sounds quite ridiculous, if you don’t mind my saying so.

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avatar Luke Landes ♦127,485 (Platinum)

I don’t mind, but “family” isn’t the only reason the mathematical “snowball” approach isn’t the best for all situations. Psychological benefit can outweigh a small financial benefit — not as a rule, but as an exception.

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avatar Paul

A couple of points:

In a way, it doesn’t matter which debt gets paid down — either way, you are paying less interest, which is an advantage in the long run.

Paying down the car first makes sense, in part, because although it is a lower interest rate, the asset behind it is depreciating (thus there is always some risk — however slim — of being upside-down). I would guess that the value of your college-educated brain will continue to appreciate for some time.

Finally, nobody mentions the tax benefit of student loans — that the interest paid is deductible. Thus the “real” rate of interest for the student loan is lower, and makes the difference between the two loans even smaller.

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avatar Kate

I think your comment that psychological benefit can outweigh a financial benefit is more true than most people would admit.

I’ve been juggling 0% deals for years now as I try to pay down a significant amount of debt. Finally, a few weeks ago, I realized I couldn’t handle the stress of the multiple payments and worrying that I might miss one, so I decided quite happily to put my debt on one credit card I have that has a very generous credit limit. They made me an offer of 0% transfer fees, but I have to pay interest every month.

It might not be the most finacially sound move I’ve ever made, but I already feel better. I think I had about reached the end of my tether.

I need a break from the stress. I figure I’ll have 6 months or so of time to recover and then I can again hunt up some 0% offers and split up my balance….

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