When it comes to mathematics, certain facts are universally agreed-upon. For example, regardless of your culture or educational system, you must agree that one plus one equals two unless you mistakenly fall for an invalid proof. When dealing with money, why are people inclined to believe that one plus one does not equal two?
If you have a certain amount of money available to pay off a portion of your credit card debt each month, even if that certain amount changes, there is a mathematically correct way of paying off that debt. You can call this approach the Debt Avalanche. It is similar to Dave Ramsey’s popular “debt snowball” method, with one small but important detail: With the Debt Avalanche you will pay off your debt faster and pay less total interest to banks and lenders.
The simple calculation for the Debt Avalanche requires only the interest rates for each debt account. This assumes that all debt accounts have the same tax liability, but if that’s not the case, determine your interest rate after taxes for this calculation.
Step 1. Order your debts from highest interest rate to lowest. You may find credit cards at the top of the list. It’s typical to see interest rates from 10% to 20% or more. Credit cards offered by stores often have the highest interest rates, so you might find these at the very top. Watch out for promotional rates ending, which they may do on the date promised when you enrolled, or earlier. Card issuers also re-evaluate their customers every so often, and will not think twice about raising your rates midstream. Note that if your credit improves, they will not magically lower your rates. While lenders will notify you if they intend to raise your rates, you may have missed the notice.
Your mortgage and home equity loan may be the next debts in line. It’s important for your list to capture every debt for which you make a monthly payment. Student loans may be the last on the list, particularly if you qualify for tax credits. The Debt Avalanche formula won’t work properly if it covers only a portion of your debt, so consider all accounts.
Order your list from the highest interest rate (after tax) to the lowest. You may have noticed we didn’t factor in your account balances in the above formula. That is because your individual account balances are irrelevant. The issue solved by the Debt Avalanche is the best way to pay off your total debt with all available funds.
Step 2. Pay the minimum to all debts every month. If you’re writing down your list, or using a spreadsheet like Excel, add a column next to each debt to list its minimum monthly payment. This is the amount you will pay towards each debt, except for the one account listed at the top of the list.
Another column should list the payment due date if it is relatively static from month to month. For example, my credit card payment is due on the last date of almost every month, so I would write “30.” This would indicate to me the last date of every month. Your payments should always arrive before the due date. In fact, in some cases, you can reduce your total interest paid by paying weeks in advance of your due date.
Step 3. To your debt with the highest interest, send all extra available cash. If you have an emergency fund, this step is simple. Since it’s unlikely that you can earn more in savings than you can “earn” (reclaim) by paying off your debt, all your unused income after paying expenses (necessary and discretionary as you see fit) should be dedicated towards the debt account with the highest interest rate.
Step 4. Repeat every month. You cover all your bases by ensuring every creditor receives the minimum payment, but you hone in on only your debt with the highest interest. Once a debt account has been eliminated — and it may not be the account at the top of the list if other balances are smaller — remove it from the list and re-order if interest rates have changed.
It’s that simple. This is mathematically the best method for paying off your personal debt. No other method will get you out of debt faster and save you as much money.
Despite the facts, many people disagree. The primary reason detractors, or supporters of the “debt snowball” method, may argue is that Dave Ramsey’s method will help you pay off your smaller debt faster, providing you with “early success” and possibly the motivation to continue along the path of debt reduction. The Debt Avalanche will also provide early success, but if you need special motivation to continue your monthly payments, consider this: By choosing the Debt Avalanche method, you will pay off your total debt faster, you will pay less interest, and you are mathematically efficient.
That is motivation enough. Or is it?
Dave Ramsey believes his “debt snowball” method, in which debts are paid off in the order of balance from lowest to highest, has shown better results than any other method thanks to “quick wins.” If he were to ask his followers if they want to carry their debt longer and pay more interest throughout before offering the “debt snowball” method, they would choose the faster, cheaper, better option of the Debt Avalanche.
One of the many reasons people can fall into debt is the difficulty of separating emotional thinking from rational thinking. The Debt Avalanche helps separate these two methods of thinking, as the best financial decisions are almost always the rational decisions. But it helps to pay attention to some of the psychology involved, as well.
The possible motivation due to the “early success” aspect of the debt snowball method is cited by many followers to be its strongest point, encouraging debt reducers to continue down the path. Followers of the mathematically and financially superior Debt Avalanche, if they need this sort of motivation, can achieve the same effect by defining milestones.
Rather than “celebrating” when your first full credit card or other debt account is paid off, take note and reward yourself when you’ve paid off your first $1,000 (or $500 or $10,000, whatever is applicable to you). Setting and achieving these short term goals influences the same area of the brain (the mesolimbic system) as the act of paying off the first credit card and are similar enough to provide the same motivational results.
Quick wins may help to motivate debt reducers to continue along the path, but the real win comes in knowing you’ve made the smarter choice.
If you need help in paying off your personal debt, consider signing up for a free-trial with DebtGoal. DebtGoal can help you budget your creditors appropriately and pay the highest interest debt first.
Photo: Ai@ce
Updated July 28, 2011 and originally published July 7, 2008. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.
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Lets say you have a Visa, Gap card and and Best Buy for example. Well the high interests ones would be the Gap and Best Buy but they more than likely would also have the smallest balances. if you owe 25K to the Gap you have bigger issues than debt.
So pay off the Gap card, then the Best Buy then you will have more money to dump on the lower interest and higher balance of the Visa.
I totally believe that paying off your Gap card with the 495 dollars is going to give a person great satisfaction and motivate them to keep going.
These were all true. But I think paying just the minimum is not enough. People should try and pay more than the minimum if possible. Also, don’t be afraid to ask your friends and family for help. Credit card debt is a scary thing!
I never had the option to ask people for help outside of one relative paying for my rent while I was in college. As such, I have always had to fight my way through in life. Of course, what I deal with these days is very minor (even though I am still raising 5 girls with still having student loans and a mortgage to pay on) compared to what I had to deal with for the first 25 years of my life. To be quite honest, from the time I was 6 years of age up to the time I was no longer had the epileptic seizures via the laser brain operation, those 15 years were horrible years for me. Not really so much cause of the seizures, but more so cause of how I was treated by others with me having 3 life strikes and like in baseball, 3 strikes and you are out, thus how I was treated by others in life. As such, I had to learn early on how to fight for my ownself and make it through in life.
Huh? Was there actually a point to this comment??
On the one hand, other than for that one relative helping out with my shelter expense while I was in college, there was no one else to help me out with my living expense or with debt. As for me getting this help, I look at that as more of lucky for me than anything else.
One of many lessons I learned growing up as a result of what I had to deal with, you can’t depend on anyone for anything as people will do anything and everything they want to do for as long as the consequences aren’t great enough to deter them from such actions, even if it means they hurt others in the process.
As such, I had to learn not to do anything that could get me into a predicament of needing help from anyone, and yes, this applies to finances as well. I basically had to learn how to do it *ALL* my own self and depend on no one. As such, don’t depend even on your own family or friends for any sort of help. If you do, it often times comes with all kinds of problems that you don’t want to have to deal with.
Another thing, no matter how tough you may think you have it, there’s always something much tougher out there that is currently being dealt with. Like me having to deal with my own debt situation (More so as a result of lack of sufficient income for necessary living expenses) was minor compared to me having to deal with the issues that I had to deal with growing up. Therefore, when the tough get going, the going get tough. For me, I used the computer to majorly help me address the financial issues.
Hello Ronald,
This is off the subject but I have a friend who’s had numerous unsuccessful sugeries for epileptic seizures. Can you refer me to your surgeon and hospistal?
Thank you,
Larry
This was done with Dr Privitera as my primary physician (and he is still there) at UC University Hospital in Cincinnati, Ohio. Dr Yea was the neurosurgeon. The office itself is the Mayfield Neurology office on 222 Piedmont Ave, Cincinnati, OH 45219. Here’s the website: http://www.med.uc.edu/neurology/partners/mayfieldclinic/index.html
Did you have your eyes closed while reading this article? The idea is to pay the minimum on your lower interest rate debts, and use all the extra money to pay off the highest interest rate debts first. So please make sure you read the article next time before commenting and giving people a clearly invalid opinion.
Well this is called a Debt Avalanche. I understand your concern in regards to paying the minimum amounts (in traditional methods of paying bills) but remember that you are only paying the minimum so you can then put your remaining resources ($) towards the biggest interest % debts. I do not believe it was mentioned in the report but it is important to know that once one debt is paid off you then take the amount you were paying on the first debt and start putting that towards the next highest debt on the list. This is what creates the “avalanche” effect. The Avalanche will not happen if you pocket the money each time a bill is paid in full.
It was sort of mentioned. By following the ‘rules’, the new ‘extra cash’ is not ever pocketed because the main rule is that all extra cash after paying for monthly expenses goes to the highest interest debt. It should go without saying that, for ‘spenders’, getting out of debt is a lifestyle decision and should be viewed similar to addiction behavior modification. It takes great will power and tenacity.
I struggled to decide which method would work best for me — as an engineer I was drawn toward the avalanche method, but I also thought there is something to buying mental victories via the snowball method. In any case, I needed to get some actual numbers down to help me make my decision. Overall, assuming that I would continue to pay at least what I pay now as the minimum, I found that I stood to save at most $623.72 on my 8-card $33,355.80 debt. I would arrive at this differential-savings high-point by paying $671.78/month for 5 years, 2 months. Realize that this savings advantage — between the snowball and avalanche — shrinks as your payoff duration decreases. I was slightly disappointed because I actually thought the savings potential would be higher than that. In any case, analysis can be found here: http://breadfromscratch.com/tools/credit-card-repayment-calculator-debt-snowball-versus-highest-interest/
When I woke up August 2008 and realized how foolish I had been with my credit cards I created a system that would work for me. Only after that time did I start reading about Dave Ramsey and avalanche approaches to paying down debt. I switch it up, I made choices that worked for me, and I made some choices others say DON’T DO, but I had to make those choices. August 2008 I had a mortgage, a bike payment (stupid purchase), 10 credit cards, 3 high interest lines of credit, and one bank loan. It was exhausting keeping track of those bills along with utilities, cable, food, fuel etc. So I took out a home equity line of credit and combined the 3 high interest, and one bank loan. I refinanced my bike loan with my bank at a lower interest. I listed my credit cards by lowest balance. It was slow the first 5 months but in February 2009 I sat down and reviewed my progress, I switched it up some, sold the bike, went to my bank once again and took out one loan for a credit card that was adding more to my “advances” each month. November 2009 I refinanced my home to a lower interest and included my second mortgage. Today I am down to one mortgage, 3 credit cards, one bank loan. I am now focusing on the highest balance card. I send double payments to 2 and triple payment to my largest. I am down nearly $19,000 of over all debt. Nearly $82,000 at the beginning and now at $63,000. and most of that was really between February 2009 to June 2010. It boils down to what works for you, not others.
Thanks for your suggestion. My head was just starting to spin as I was trying to wade through the information I already have and researching other methods in order to make the best fiscal decision for me. I am working hard to be more financially responsible and clawing my way out of debt slowly but definitely surely. Your words gave me the confirmation that it indeed boils down to what method works best for you and not what others tell you. THANKS and good luck at working your plan. (From the looks of it, I don’t think you need it! :)
This was really inspiring, I have a visa that I owe $2,480 haven’t been able to make payments but I’ve talked to the debt collectors and im so lost with everything. I’ve tried to transfer to another credit card but I only got a credit limit of 300. Do you have any suggestions as to what I can do? Im a college student and my funds are really limited and the debt collectors are asking for the whole amount which of course I am not able to get.
I agree that people should do WHATEVER method gets them out of debt. I like the avalanche method for my family and me.
I took the FPU course with my wife as I more or less forced her to take it. Main reason for me having her take it was cause I was sick and tired of her thinking all of this financial stuff I had been doing in Excel was just some made up stuff in my mind. She dreaded it at first, but after the course itself via the video showed some real life experiences and others in the classroom shared their experiences, it made it all too real for her as it reminded her of the various things we went through. This was the purpose of me having her to go through the course as I had to have her realize what I was doing was the real deal, not just something made up in my mind. She came to that realization pretty early in the 13 week course.
As for the debt snowballing area, I’m with you as I don’t agree with Dave’s method. Not only does Dave highly recommend the principle method, but so does Primerica, which I also refused them with this principle method.
Like you pointed out in this article, I also take taxes into account. As a matter of fact, I even took it one step further. Within my Excel financial file, I have done the following:
Column A: Debt Title
Column B: Debt Principle
Column C: Stated APR
Column D: Before Tax Basis Effective APR
Column E: “Yes or No” answer – Is it Tax Benefit (Example, Student Loans, Yes, Mortgage, No (The Schedule A has never been of help to us, even under the 13/11 month game)
Column F: After Tax Basis Effective APR
Column G: Minimal Monthly Payment
Column H: Principle Reduction
Column I: Daily Savings on Interest with Debt Payment
Why do I have Column I thrown in there? Well if you know how money works, you know it works more on the basis of percentages than it does on absolutes. Therefore, the higher we can get those daily residual savings in, the better off we can be. Over the course of the year, I set the goal to be a minimal of $3.65. To some that may seem a small amount, but think about it. If you have a debt with an ATBEAPR of 10% (using this rate for simplicity purposes when it real life, it may very well be a much more decimal type number), for every $10 you pay off on the debt, you save yourself $1 over the course of the year, so to save $1.00 per day or $365.00 over the course of the year on interest, you have to pay down the debt by $3,650.00. Another words, if you were using strictly this debt to save you a daily interest charge of $3.65, you have to pay down that debt by $13,322.50 over the course of the year. The lower the rate, the more you have to pay down the debt or pay into the investment to achieve that $3.65 daily residual amount goal.
Don’t kid yourself, you do have to convert everything to after tax basis before you can tell if you are meeting this $3.65 annual goal or not.
There are 3 major issues I have with Dave’s FPU course:
First, it’s too risk adverse. It is truely a cash flow method that even under my retirement self study has already proven to be too slow of a route to secure a retirement security when you throw in life circumstances one is faced. For me, I use my method, which still greatly take risks into account, but it’s what I call the equity method as it’s main goal is to shoot the Long-Term Networth value up as high as it can without taking on too much of a risk that may hurt this value in the long run.
Second, the numbers in that course are too outdated. Examples:
It’s baby step 1 says to have an emergency fund of $1,000. That may have been true in the 1990′s, but not now. Now, this step should read as a $2,000 level.
It’s baby step 4 says to ultimately get to 15% of gross income into retirement funding. Again, this was the most you were allowed back in the olden days prior to the 2003 bush tax law changes. However, under my self study of retirement, I found 25% is the ultimate goal, but even after the initial 5 years out of college, you at least need to have 25% of actual gross income (that is including the money the employer put into the retirement account on your behalf) must go to countable savings (Net contributions into retirement funding including the matching money from the employer, net debt reduction, and net emergency fund contributions). Why not within the first 5 years out of college, generally your income start out really low and you are jacked up with high debt of student loans to the point the government of recent even subjected the CEOs of these various colleges and universities they are charging way too much and thus these people with these high student loan debts are defaulting on them majorly. Therefore, the first 5 years of one’s work career, they are in too much of a financial dire strait to even think about putting money into retirement debt. Yes, I was one such person specifically in this boat and I’m still paying on such student loans for another 8 years or so yet.
Third major issue I have with his program. While it’s true, his method allows for one to do things without having to think about it daily, but once again, his program is behind times, and you can now use online tools to schedule your payments in advance of time. As such, now you can use the rate (ATBEAPR) method primarily to determine how to pay down your debt.
The only caution I throw in there, if you have a debt with transaction fees for extra payments (I.e. 401(k) loan payments) and/or early pay off penalty charges, you must be careful and really think it through if it’s worth it or not. In my case, I had to face them both and for them both not to be worth to take on such fees. Even with the one dealing with the van, I had to be smart as to how I dropped the debt on it and believe it or not, for a loan that was expected to be paid off in 5 years, I shaved off 5 months worth of payments (that’s money saved and not paying into interest by turning their rules around to work for me instead of for them). I still don’t have it entirely paid off, but the balance on it is so low, the interest charged on it is negligible on it. To avoid that early pay off penalty charge, I have to wait until the earliest possible time I can pay it off without getting hit with that $125 charge. The rep claim one year left on the loan is when it will fall off, but the paper work says it’s 6 months left. Either way, I’m covered as I already paid it down in a manner I have given myself some cushion room.
David Ramsey’s method is about changing behavior, not just paying off debts and creating emergency funds. The initial emergency fund should be $1000. It’s created to get you in the habit of saving money, and to provide buffer between yourself and emergencies. However, he says that you should increase its size later.
Most people I know make 2 emergency funds:
1) Unplanned expense emergency fund
2) Job-Loss emergency fund.
3) The other idea I subscribe to comes from Youneedabudget.com, which has you create a buffer equal to 1 months income. This is used to fund next months expenses, so that you are always pay this month’s bills will last months money. It’s another way to stabilize your money flow as you don’t have to worry about how much you will have to spend…you already know that.
4) Finally (for me) , the debt snowball. You can choose your strategy, but I found that having 20 creditors that I owed small amounts to calling me, sending me collection notices/threats, making entries on my credit report, etc. was worse than paying more in interest. So, I went after the small debts first. I found I knocked half of them out in the first 3 months. Not having to deal with them lowered my stress level big time, I slept better, and my quality of life improved greatly.
As I continued down the line of small debts, I found it took much less time to take stock of my debts and decide how to pay them, or who to call because I couldn’t pay them due to an unplanned expense. So that management of my debt was much simpler as well.
My mini-emergency fund will be done next month, and I’m way way more in control of my finances. I finished off 3 more small debts this month,and plan on knocking out 1 a month for the next 3 months.
This will leave me with 5 fairly large debts to pay off. With the free time I have since I don’t have to deal with a million creditors, I can work on negotiating lower interest rates, getting a second source of income, and look at different strategies in paying them off sooner.
If I had gone after the largest debt first, I’ll still have several years left to pay on it, and still have 20 creditors breathing down my neck, and probably I would have jumped off a building by now.
Why I say $2,000 for the first baby step?
Let’s say you have a major vehicle problem. Now days, you might get lucky with that $1,000 amount, but most likely, you are going to be more like in the area of about $1,500 like with a transmission or engine issue.
Well congrats on how much progress you made at this point of time. As for you doing the smallest first, I normally would have been against it, but in a case like yours, I could see why you would do that for various reasons. If you have small debts like that that can be knocked out within 3 months, then it generally means they are of the insignificant effect when compared to the big picture.
Well, once you realize there is more to the equation than interest and fees, you’ll understand that it’s not as simple as choosing the debt with the largest interest ( you can have a gigantic interest-free loan, and several smaller but interest-laden debts, so then paying the largest debt will not save you any money on interest, this happens to be my case ). There are factors such as fees, how many hits on your credit card ( do you want to have 4 ( 3 small + one large ) or 1 ( just the large one ), the management overhead for keeping track of all of these debts, and handling issues with them. For example I have a creditor that I made a deal with , and they said the paperwork had to go to another department. Two weeks later, I called because they didn’t process my payment, and they rep said for some reason it was never sent to the other department. Another two weeks pass, they withdrew the amount of the first payment in the payment plan, but I get a threatening letter saying I am delinquent in my payments and must pay the entire balance in full now. Since I’m in Asia and have to wait for the office in the US to open(13 hours time difference ), its quite a hassle to have to keep going back and forth like this. Now imagine I had the choice of having 20 accounts like this to deal with, or 10 ( because I pay the small debts off first ).
Personally, I’d rather have the 10.
Then there is the psychology behind it. Some people are motivated to go forward by positive feedback. A number of quick wins makes evident that they can achieve their goal, and it’s been show in studies to build an “addiction” to paying off debt. Often slow progress builds a sense of hopelessness, even though you can show them that balances and fees are decreasing, they still don’t get the same satisfaction as the words “paid in full” bring.
Finally, I leave with Sun Tzu’s ( Author of “The Art of War” ) strategy of throwing your strongest forces against the enemy’s weakest point. It works.
With that second to last paragraph of yours, you are right, many people are driven that way. For me personally, I am not driven that way. If I had to deal with creditors like that, then I would be like you, get rid of them creditors as quickly as I can. On the other hand, I’m not in that boat.
One more thing to think about, there are also other debts like debts against 401(k) plans, which if you pay extra on, you also end up paing something like a $15.00 transaction fee per extra payment, thus from a mathematical point of view, does it really make sense?
I know when it comes to 90% of the people in this world, it seems all logics goes right out the window, thus why people like Dave Ramsey says it works so well, it *MUST* be the best way. Well it may be for the 90% of the people in this world, but not for the other 10% that are logically driven. For me, that bottom number is the only thing I really care about, though I certainly look at other aspects of the family’s financial health, but ultimately what really makes the difference is that bottom line. The problem I have with people like Dave Ramsey, since this works for the 90% of the people in the world, he attempts to lay the claim it works better than the rate method for the other 10% of the people in the world as well thus attempting to stuff it down people’s throat that are rate minded.
Like you said, even though I am primarily rate minded meaning I primarily go in rate order, I also take other things into account that could change that order for one reason or another, which I have had to revert to that from time to time.
Speaking of psychological aspects of the human body, let’s look at another one of Dave’s comments that I also don’t agree with.
His argument for renting vs owning:
You rent until you have all of your debt paid off and you have saved at least 20% down payment on the home itself including all of the extra fees with it.
Mathematically, this could be very well argued from both cash flow and risk factors. However, if you had to deal with slum lords like what I had to deal with, this whole argument goes right out the door cause who wants to continue being a tenant if from landlord to landlord to landlord, they keep attempting to blame things onto you as to it’s your fault as to why certain things are not working properly or why there’s a crack in the foundation. They don’t maintain the building and when they do have the so called maintenance guy over in the dead middle of the winter to fix something in the rental, the maintenance guy leaves the windows wide open, which then leaves the home and still leaves the windows wide open only for you to end up having a much higher heating bill. After having to deal with such issues for a period of 12 years (much of those years were on a basis that my income was too low to even cover necessary living expenses thus a relative had to pay for the rent). The last slumlord I had was even worse. He not only had those things done, but he even attempted to play the late game with my rent payments, thus whenever he claimed my payments didn’t get paid on time, I relied on the bank’s online banking guarantee with online payments. I followed the rules to the T and thus I had a valid means as to my payments at least based on my instructions were “ALWAYS” ontime. As such, I not one time had to pay the late payment fee as done via the bank’s guarantee with it’s online payment program, which the slumlord attempted so many times to get me to pay such fees along with sending out 3 day eviction notices for failure of payment. The last time he did that was when we had given our 30 day notice and he instantly out of retaliation sent us a 3 day failure to pay eviction notice.
As such, even though I was logically looking at total cost of renting vs total cost of owning a home, I had this major emotional drive to get out of the renting business as a tenant. While the owning worked out to be less cost over all than renting, we still took on a major risk that we would be able to keep up with the mortgage payments along with everything else. We ended up taking on a greater risk than what I wanted to take on, but I was so driven emotionally to get out of the renting business, I in many respects really didn’t give a care as long as it wasn’t going to land us back into the renting business as tenants. Therefore, even Dave’e deciding point of when to go from renting to owning was not even going to come close to be followed cause of all the BS we had to deal with as tenants. That right there is my single biggest reason for leaning to ownership. While I would primarily have the total cost of renting to owning being the primary decision factor with risk factors thrown in to be taken into account, you got this psychological factor of having to deal with such slumlords too.
Now that I have my debts pretty much under control by getting rid of the small ones quickly, the overhead of handling a large number accounts is gone and I can plan a lot better. Note that interest rate/fees and balance are 2 different things, and you may have 0-interest debt ( like items in collection with a payment agreement ) and interest debt ( mortgage, revolving line of credit, etc ) .
That said, I’ve changed my strategy to consider fees/interest as well as balance. If 2 debts have a similar balance ( this is highly subjective ) but one is costing more in fees, then I would recommend paying minimum on the low fee one and as much as you can on the high-fee/interest one, even if that is out of order for the snowball method.
your plan to consider the interest rate on two debts that are similar in balance is actually part of the snowball method. Dave Ramsey says that when ordering your debts in order of balance if two have a similar balance you should list the higher interest rate one first as it will save you interest payments in the long run! So you are still using the snowball method when doing this. Great job!
I had not heard of this approach before. Good article. Thanks for the information.
Thanks for the article, this gives me a good place to start. I have 2 credit cards neither of which I felt like had unmanageable balances until I started considering how high my student loan payments might be when they begin in 3 months. Reading this article makes me feel a little less anxious, and a little more prepared.
Question – I have 2K on a credit with 0% interest for a year and a car loan of 3K with 5.4% interest on. My wife and I will owe big on student loans in Janaury and I want to get my car and/or credit card paid off fast. Should I pay extra on credit card payment or car? How important is it to pay off the 0% in one year, the interest will shoot up to 10% in April 2012.
Thanks
Great question, Paul. I’ve responded with my thoughts on your situation here.
It’s really a depend type question. Initial response would be to get the car paid off first, but without knowing your cash flow situation (inflow vs outflow for the time period of the 0% APR). However, one thing about that 0%, if the terms states as if you don’t pay it off in full by the end of the promotional time period, then you will owe interest that incurred during the introductory time period, but wasn’t shown to you as an expense given you were in the introductory time period. Given the rates of most of these promotional things, that’s quite often a very high rate and it’s a big money thing for them. Therefore, if there is this back interest clause in your contract, then it’s very important to pay off this debt before this 0% introductory period comes to an end.
With this in mind, this may mean instead of paying off the extra to the car debt, you may need to save this extra to a saving account that may earn you a very small amount of money until you build up enough money to pay off this 0% APR debt in full (Before the end of the intro period), so as you avoid the big interest charge that would take place otherwise once the end of that period has past.
Of course, for you to figure this out, you need to know your cash inflow, your necessary cash outflow and your other cash outflow demands, which then to determine what you can and can’t do along with determining what’s best financially for your household. I know this sort of thing isn’t the easiest to figure out, but it’s the number one reason why I use Excel for my financial stuff. Rather than me having to do all of this stuff myself, I just simply setup the calculations and let Excel do the calculations for me.
Hello,
I’ve been reading articles about paying off debt quite a bit. I’m not in a whole lot of debt but I feel like I can never get out of it. I have two best buy credit cards that are interest free as long as I pay roughly $80/month due to the promotion they had going on, one has $750 and the other has $1400. I understand that’s basically free money but I hate having that debt over my head. I also have a visa credit card with $3000 on it, which doesn’t start accruing interest until September which will be a 17% interest rate. I have about $500/month available to pay off debt. Which one goes first?
I’d pay the minimum towards the Best Buy cards and blast out the Visa card as quickly as possible. That 17% is a killer.
I have opted for a hybrid method between the snowball and avalanche. My wife and I have student loan debt and a mortgage, that’s it, although the student loan debt is high about $80,000 EACH. The credit card debt of $11,000 that we had is gone, that was priority. Then came the private student loans with high interest, a $7500 one is gone and another that was $22000 is now at $15000.
Right now we are probably following the avalanche method in part by paying the mortgage+ $100 extra per month to eliminate a few years off the 30 year fixed at 5%.
The student loans have the highest interest, the private $15,000 is at 8%, mine at $80,000 is at about 7% and my wifes at about $80,000 is at 5.75%
Right now I am sending $2500 per month to my $80,000 loan and at least $1,000 to the 8% loan. My concern here is more with the total amount of interest that racks up on the higher loans, combined with eliminating the highest overall interest rate loan. So it’s a combo method that includes both elements.
However, one of the loans at $80,000 I leave in forbearance, this is the lowest interest rate student loan. The idea is to pay off the higher interest lower balance $15,000 loan and then tackle the larger one later.
So basically I owe and pay the following
235,000 mortgage, pay the “minimum” 30 year payment with + $100 to pay down some principal
80,000 Student loan at about 5.75 in forbearance
80,000 Student loan at 7% pay $2500 per month total interest per year is about $4,500 everything else pays down principal
15,000 Student loan at 8% pay $1000 (sometimes more depending on second job income)
So I think I have combined both methods. I still poke some money into a high yield savings (wow about 1%). So psychologically this works because I can see at least one large balance dropping dramatically (the 80,000 loan I give $2500 to per month used to be $105,000 less than a year ago) I am still saving money each month so my savings rises, and I can see a smaller loan (the $15,000 loan) being wiped off in about a year. Then that income will go to the second $80,000 loan which will get eaten down some while the other large loan gets paid off.
An alternative I thought of is to take each and pay all available income to just one and wipe each out quicker. Since Student Loans with the Fed can be put into forbearance then this was tempting. One would dramatically drop while the other only rose slightly (since student loans are not revolving credit accounts).
It was also tempting to forget the student loans and pay off the mortgage, then the student loans. The logic being that the house is a tangible item that can be taken back in hard times, while student loans can be easier to deal with. We have been burned in the past by sinking money into housing that then disappeared to the tune of $60,000. So that experience taught us that real estate is volatile and that equity isn’t a guarantee. So we decided to attack the student loans but give a little to the house.
Thoughts ideas?
Appreciate it, we are both in non finance related fields and appreciate the assistance.
as for the $80,000 with 7% stated APR vs the $15,000 with 8% stated APR, I would at this point pay the minimal to the $80,000 and pay the extra to $15,000. Under both rules (Avalanche-Rate and the Snowball-Principle), it would say to pay off the $15,000 first. The Avalanche-Rate says cause the rate on it is higher than the rate on the $80,000, thus you will save on total interest charge overall. The Snowball-Principle would have you pay off the $15,000 first cause it’s closer to being wiped out, so it would free up cash flow sooner as it would drop your cash flow demand that much sooner.
Note, in most cases, I would go with the Avalanche-Rate method, but there are cases for going with the Snowball-Principle method. However, before you decide which way to go, you have to look at your household’s set of circumstances and decide which way to go, which there are 3 basic ways to go with regards to being financially prudent depending on your household’s set of circumstances.
1) Put so much money into an emergency fund (which I’m assuming that’s what your so called high yield saving account is for) for when something happens, you have something to fall on. Like in my case, I have an emergency fund of about $13,000 that is mostly invested, but also easily converted to cash with very low cost to do that. Don’t get me wrong, I still have taken some risks with the route I have taken, but I would rather take on market risks than to lose to inflation risks.
2) If you feel there’s some eminent risk to your current cash inflow (i.e. unemployment) or some other major cash flow demand (i.e. vehicle repairs), and you not sure if you going to be able to get the cash freed up in sufficient amount of time, then you may choose to take the snowball-principle route so as to get rid of debt quicker, which then will reduce your cash flow demand faster initially even though it will end up costing you more in regards to total interest you pay. However, by going this route, you may also potentially save yourself from having to take out other debt that would incur other fees and interest charges. Not only that, but if your situation looks to be pretty bleak, you may end up having to get rid of the smaller debts not only for the cash flow demand reason, but to allow you to make it through that much more easily. Example, if you end up having to rely on the state/federal welfare system, you can’t have more than $2,000 in countable assets including your emergency fund, so you may be forced to pay down your emergency fund to get any sort of welfare help from the state/federal. The other thing, the welfare system doesn’t take into account any of your debt(s) except for your mortgage (if you have at least one), which they only allow for one mortgage. I know this is not an ideal way to go, but there are such cases you may have no choice but to go this route. However, be very careful you don’t get caught trapped in the welfare trap with these rules, which many people do fall victim to.
Side note: I have been notified as of mid part of next month, I will be laid off, so I am having to do what I can with what I have in my control. With what I have done thus far with raising a family of 7 (my wife, 5 girls and myself), in theory, I should be able to last for a minimal of 9 months should things end up getting bad, but I really don’t want to have it come down to that. However, even with that, it would mean my networth will be depleting faster than what I would like it to be. Therefore, to counter act that and knowing the welfare rules, I may pay down my mortgage enough to get rid of the MIP and pay off one of my student loans so as to greatly drop my cash flow demands while then allowing us to qualify for this welfare help on account of us no longer failing on account of that $2,000 countable assets rule. By doing that, it would allow us to get the help, which then would keep the networth from dropping all that much even though our daily residual improvement goal would be greatly hurt by this move cause of us having to give up the residual income that I have been getting from the emergency fund (which I estimate to be about 7% return after tax basis to be on the conservative side even though I actually have done better than this. I would rather be conservative than over zealous).
3) If you are in pretty good shape with a healthy emergency fund in relative comparison, you can take the Avalanche-Rate route and really cut down on your total daily interest charges. From strictly a financial or mathematical stand point of view, this is by all means the most preferred route, but if there are certain other things that are weak, taking this route can end up costing you more with regards to other angles of financial fees, especially if you end up having to take on other debt cause of some other situation happening that requires you to come up with some significant amount of cash rather quickly.
Example with my current case. I had been using the Avalanche method, but as of late last year, I been having to switch gears cause of things I saw at my place of employment I have not liked and me seeing those things in advance of time proved to be right. As such, I have been building up my emergency fund and allow me more options should things happen, which obviously they have now been put into action to happen.
One of the things I learned back in the 8th grade as a result of how I was treated by the school officials with me having 3 life strikes (epileptic seizures, learning disability primarily in language, and being a ward of the state or foster child), one much learn the adult’s game, strategize within the rules of the game (heaven forbids should you break one of those rules), and ultimately beat them at their own game. What forced me to do this was when they were attempting to hold me back laying the claim I couldn’t do anything including my strong subject matter areas, which I ended up proving them wrong in so many ways they had no realistic choice but to admit they were wrong for applying those myths to me. Same here with this financial stuff. Learn the rules of how finances/money works, how the creditors work, and how the government work, which then work the system to your advantage. While you do things that should be right for all people, but if worse comes to worse just as they did for me when I was a child growing up in the public school system with nearly all of them treating me like I couldn’t do anything cause of me having 3 life strikes (Like in baseball, 3 strikes and you are out), then you have no choice but to turn to such down right playing the rules against the ones that’s attempting to hold you back. With regards to finances, I apply many of these rules to better ourselves while still being fair to the creditors.
Make the payments as you currently are, if that is what you can support. Your total monthly payments total roughly $4850 given what you’ve said.
At this rate you’ll pay off the $15,000 student loan around October 2012.
Once you free up that $1,000 then you should apply it to the 7% student loan (on top of the $2,500 you are already applying).
Paying that $3,500 into the 7% student loan, you should pay it off around December 2013.
Once you free up that $3,500 then you should apply it to the 5.75% student loan. That will allow this loan to be paid off around April 2016.
At that point if you direct the entire $4850 into your mortgage then you should be able to pay it (the final item of debt) off around April 2020.
This approach will yield you around $100,000 in accrued interest.
This payment approach is based entirely on minimizing accrued interest assuming monthly debt payments of $4,850 … by the numbers. No consideration was given to preferentially paying off the mortgage first or last.
Here’s a question that that I have not been able to find an answer to.
Instead of either method, what about putting whatever extra money available monthly on the debt (credit cards in my case) in order of the HIGHEST MINIMUM amount due. This may not be the smallest total amount owed (Snowball), nor the highest interest rate (Avalanche). Once that comes down to a monthly minimum payment equal to the next card in line, then tackle the one with the highest interest rate of those two, etc. I can see the possibility for yo-yoing the various CCs as the minimum amount due change – so maybe more labour intensive. Is this a good approach – does this have any advantages or disadvantages over the other two plans? Thanks!
I ran numbers to test the theory on both Snowball, Avalanche and, what I call, Power method. Power method prioritizes the debt where the payment would give the largest reduction in daily finance charge.
For example, $25,000@5% costs $3.34 a day.
If you pay $1,000 towards it, $24,000@5% costs $3.20 a day.
So, the power of $1,000 applied to this debt is $0.14/day.
$5,000@15% costs $1.91 a day.
If you pay $1,000 towards it, $4,000@15% costs you $1.53 a day.
So, the power of $1,000 applied to this debt is $0.38/day.
Given the choice, $1,000 does more good on the $5,000. These examples are rather obvious and Debt Snowball or Debt Avalanche would lead you to make the same choice.
Here’s the kicker … for a given interest rate … the “Power” that a $1,000 payment has on reducing finance charges is the same, regardless of actual account balance. It might not make intuitive sense but, whether you knock $25,000@5% down to $24,000@5% or you knock $2,000@5% down to $1,000@5% … that $1,000 is reducing your daily finance charges by $0.14 in either case. Paying the $1,000 towards higher interest rate items givens you a larger reduction in daily finance charges.
Debt Snowball might be good psychologically for ‘quick victories’ but Debt Avalanche will result in less interest paid. If your debts happen to have higher account balances associated with lower interest rates (which is not uncommon… think new car loan vs used car loan, home mortgage versus payday loan) then there is really no difference in either approach.
Other than for psychological situation, there could be other reasons for doing the snowball (principle) instead of avalanche (ATBEAPR or After Tax Basis Effective Annual Percentage Rate). It could be either 1, they need to free up cash flow to get them on better ground (hence they may have to go this route to help them avoid other potential finance charges that they may potentially incur otherwise with the rate route if they are in this bad of a situation), or it could be they need help from the welfare system to help pay for necessary living expenses, but given the welfare laws don’t allow for good finance practices (in particular allowing for a sufficient emergency fund given the household is ONLY allowed $2,000 of countable assets which includes the emergency fund as countable assets and like in my case, $2,000 is only about 3 weeks of total household cash flow demand for a household size of 7), and given no debts other than the mortgage is taken into account, one may have to spend down that emergency fund to get rid of as much of all of the other debts in order to get the financial assistance they need for their necessary living expenses while also freeing up their cash flow demand in the same process.
I don’t normally like to advocate feeding off of the welfare system as it’s really more of a financial trap, but there are cases when one may not have much of a choice but to go that route on a temporary basis. Why it’s a trap? While they claim it’s to help those that really need help, in practice, once people get onto it, they generally get stuck on it cause most people are like, why should they go back out there to work if they get more taken from them than what they get from employment. Not only that, but if you are attempting to help yourself, you get left out in the cold in most cases while if you don’t attempt to help yourself, then they do help you out. These are the 2 major issues with the welfare system that makes it more of a financial trap.
Can anyone tell me^ is it better to pay off closed accounts in collections in payments or all in once? Which one will make my credit score go up?
Be careful. If the account is old then let it go, it won’t show after they are seven years old (regular accounts). They will still try and collect for years but if you do not set up payments or do anything new with the account they it won’t go back on your report.
That being said, if they are relatively new 2-3 years (depending on how much the accounts are) you can call the creditors and work something out to pay them off for less. Go to a credit counseling workshop in your area. Most are non profits and so forth but you can negotiate on your own. Most of the time they will take less in a lump sum and the account will then show positive. Payments are not a bad idea because they can help rebuild credit and build a positive payment history.
So go get some credit counseling and DO NOT pay for it. Call the legal aid group in your area and they will have a referral for you. Start by calling your local superior court and they can refer you someplace too.
Don’t agree to anything with creditors unless you get it first in writing and you can review the terms.
I don’t understand the advice to use your emergency fund to pay off debt. Sure you won’t make as much in interest in a savings account as you would save paying off a chunk of debt, but as I’m sure we’d all agree, the first step to killing debt is to cut up all credit cards. Now if you’ve used your emergency funds to pay off debt and then something happens, what exactly are you supposed to do? You now have zero dollars and zero credit. You’re screwed. I try to keep in savings *at least* the amount of 1.5 months rent. I don’t drive a car, so to me housing is the biggest and most important expenditure. With that much ready cash, I’m prepared if my housing situation should suddenly change for any reason.
I just ran some computer code to crunch the numbers of this discussion. I simulated monthly payments being made to items of debt (each item of debt having its own ‘minimum payment’ on its own given day) and a large ‘debt reduction payment’ being made on a given day every month to a given debt item.
The selection of which item of debt the ‘debt reduction payment’ was being applied to was chosen based on:
1. smallest balance,
2. highest interest rate,
3. highest daily finance charge,
4. no particular reason (that is, simply chosen based on being first in a list),
and for kicks,
5. largest balance,
6. lowest interest rate,
7. lowest daily finance charge
If this ‘debt reduction payment’ ended up paying off an item of debt without being completely spent, the remainder would be applied to the next highest priority item.
The simulator was also run with and without ‘catch-up payments’. The catch-up payments were to ensure a certain minimum amount was being applied towards the bills monthly. That is, if an item were paid off in a previous month, with ‘catch-up payments’ the funds no longer being applied towards that previously paid item would be applied to something else … or without ‘catch-up payments’ a paid item would result it progressively less money being applied towards debt reduction with time.
The list of debt items that I used were based on my own financial situation. Generally, the larger account balances are associated with lower interest rates.
In the end I found that, at least for my situation, it doesn’t much matter whether I pay off lower balance (debt snowball), higher interest rates (debt avalanche), or higher daily finance charges (lets call it the power method) first. It does, however, matter if I choose to prioritize debts in the opposite manner … higher balance, lower interest rates, or lower daily finance charges first. So, as far as choosing which to pay towards first, it doesn’t much matter which of the sensible 3 methods I choose.
The most important thing in paying down debt faster and with less interest paid is the ‘catch-up payments’. As you pay off one debt, apply what you would have paid for that debt to something else.
In short, it doesn’t much matter what you pay the $2000/month on first … only that you consistently spend down $2000/month.
If rates and balances are either relatively close or balances or time duration are relatively very small, then it more than likely wouldn’t make much of a difference. However, if there are significantly larger rate differences with larger balances over a longer time periods with significantly different maturing dates between the different loans, then you will have the opposite end of the spectrum being true meaning the avalanche method will show much more improvement than what the other methods would do unless there’s some other financial situation that would trump the avalanche method such as early payoff penalty charges, then that would have to have a second look to see how that may change the ordering of the debts and rather to pay off such debts sooner or not.
I don’t know what numbers you are using, but for the most part with my situation, our household networth at it’s lowest point in February 2001 (by the way, this was when my income went up significantly to the point it was the first time when it was enough to pay necessary living expenses and make minimal debt payments) with a long-term networth value of about -$80,000 (Yes, that’s a negative number). Now, we are at about a long-term networth value of about $76,000 on an after tax basis with annual income only ranging between $45,000 and $60,000 for these years and having a household size of 7.
How was I able to do this? Simple. Since we already been living on such low standards of living (well into poverty level) without the help of the welfare system (cause of the fact the welfare system deny those that attempt to help themselves out in practice on account of the rules), and I certainly didn’t want to live in such poverty conditions as I did through much of the 1990′s from the time when I was first having to support my ownself with what little income I had and very little financial support from anyone else, I made it a point to take full advantage of the retirement system as soon as I fiscally could (which wasn’t until December 2001), but at the same time, I was to work on the debt situation and get that knocked down as quickly as I could which again, knowing how numbers works, I applied the ATBEAPR method primarily of determining how to get the debt knocked down.
Yes, I took on significantly large risk doing this, but I knew that prior to implementing the plan, but yet, I also knew I didn’t have much of a choice either given the financial situation I was in as a result of the debts built up from my college years including those debts built up as a result of insifficient income to live on while in college (was nearly put out on the streets as a result of this situation and yet, the state refused to help me with my necessary living expenses, even with me doing what I could do to help myself out). Oh well, that was the story of my first 30 years of my life, instead of getting sensible help as needed, got more things put up against me to make it that much harder for me to reach my goals. As such, I was forced to become so competitive to the point in college, I was accused by my own cross country running teammates I’m too competitive. Well so be it, but when you are constantly getting pushed back and told you can’t do things including things you are already doing, you will instead learn the system and all of the rules including the unwritten rules, stay within all of those rules and work the system to your best advantage and against others as a result of having been backed into a corner by others.
William asked what would great the greatest positive reflection on your credit score; paying off closed accounts or not.
TJ advised him not to pay off old collections because they will drop off after 7 years. Is this true if debt collection companies continue to buy the debt from one another? Doesn’t the 7 years start over every time a new debt collection company buys your debt from another company?
I have good repayment history and settlements for the last two years but I have about 10,000 in collection debt from 05-07. I need to know what will make the greatest positive effect on my credit score in the quickest amount of time.
Should I settle these accounts at 50%, wait for the 5-6 year old debts to fall off in a year or two and settle the newer ones?, or make a payment agreement with all of the collection debtors and start the avalanche/snoball method with all of these payments?
Pay off the newest accounts with the highest interest rates. If you have stuff that is 5-6 years old forget them. Don’t agree to anything on those. I had one account (a Gas card) from years ago when I was younger and got in terrible debt and never paid. They still try and collect and send me notices and I ignore them. They switch companies often. It does not show up on my credit at all. It has not for years and years after the 7 year deadline. The catch is that if you agree to a payment plan with them or to settle the debt, then it will go back on your account because it is new and current activity.
Personally what I would do is get free debt counseling for your particular situation. You can turn your credit around fairly quickly. From what you’ve posted here I would pay off the newest accounts with the highest interest rates after trying to settle with them for a smaller amount.
The old accounts can be sold to any debit collector and they will call and send letters even after seven years, however they know that they have a very slim change of recovering anything. That has been my experience. Why is seven years the magic number? It dates back to historical and religious reasons. Debt was arbitrarily to be forgiven after seven years, and we have stuck tot hat rule, except for bankruptcy which I believe stays on for 10? Thankfully I have not gone through that.
However, there is always a way to repair credit relatively quickly and starting with the newer is the way to go, that way if you pay off the newer and then WANT to pay off the older stuff then do so. But if you pay off the older stuff and then something happens in a couple years, (health, unemployment issues, the whole list of things that can go wrong) then your new stuff will be there for years and your credit will be damaged if you can’t pay those. If you pay the newer off first, and then something happens, at least you will know that the older stuff fell off your credit record and you have at least improved credit.
So my advice it it were me, pay off the newest first. Student loans are different, those stay around forever and lead to garnishment, tax returns being withheld, all kinds of nasty stuff. But regular consumer credit cards are limited to seven years. So if I go get a Kohl’s card and charge it up to the hilt and don’t do anything to pay for seven years, it will fall off. My credit will be horrible, they COULD seek a judgement but don’t usually unless it’s for a ton, and they will at some point sell my account to a collector who will send me letters, call me, try to get me to agree to payments and so on. And if I then do so that info (my payments) will be reported to the credit companies and that info sticks for seven years.
Been through the bad credit days and done some things I had to do to survive school and family and still paying off school loans, but have no credit card debt and credit is no issue. Yet I still get a letter every now and again that I toss in the can. It was for about $900 of car repairs that I had to get and could not pay for in about 1994. In 2003 I bought my first house and credit agencies show no record of it. I have credit monitoring and it never shows. But If I agree to payments, it will. For seven more years from the date of my agreement.
So bottom line, be careful and don’t act with haste. Check into local consumer credit agencies that will give your credit counseling for free.
http://www.nfcc.org/
Above is a good link. Make sure you pick a NON-PROFIT agency, no scam stuff or payments needed. The above link actually offers online intakes.
That’s my two cents, good luck, if it’s any consolation zillions of people are in your same situation or close to it, or have been there in the past. The fact that you can even think about your credit issue indicates that you’re in a better spot than many today that are worried about a roof over their heads and food for their families.
And it ain’t getting better soon………
Please assist me with this. I have a car loan, taken out in Feb of 2009. At the time I purchased the vehicle, I was in a negative equity with the car I traded in. As a result the loan amount was for approximately $49,294.13~ over 84months at a fixed rate of 2.62% for the first five years; thereafter it will be renegotiated in Feb of 2014. Presently, the balance is $33,027.82 with continuing biweekly payments of $296.74.
I also have a credit card debt of $5,000 @ 12.9%, just today changed over to a personal line of credit %7.5%. I believe the minimum monthly payment would be approximately $100.
I was thinking to pay the car loan off first, by the renegotiation date of Feb 2014. Do you think this would be the best plan? It will be difficult for me to meet the extra $500/mo I calculated I would need to pay to meet this plan.
What advice can you offer me? I have determined the car loan was the stupidest mistake I have thus far made and will never again do it in a negative equity situation.
Get rid of the smaller amount with the higher rate, and then go all out on the car loan.
If I was in your situation that would be my approach. The $5000 you owe should be gone quickly and you can then concentrate on the larger bill.
The only question I would have is what your rate on the car loan will be later. If it dramatically jumps then that might change things.
I suppose you’ve already thought about getting rid of the car somehow. I would try to get rid of it and buy the cheapest new car I could. By doing so you might improve the term or long term rate of your debt. Lots of car dealerships that are hurting that might be willing to deal.
Hello,
I was wondering if anyone could give me their opinion on my financial situation. I do not have any credit card debt, I occasionally use my one credit card but typically pay it off in full every month. I only have maybe $200 on it currently.
My student loan debt is what I’m debating. I currently have 3 loans out (I’m unable to consolidate, one federal loan and one private loan in my name while one federal loan is in my fathers name that I’m just making payments on). The federal loan in my name has a principal balance of $21,125.93, fixed payment of $120.64 (graduated payment plan – standard was $254.22/month YIKES), with a fixed interest rate of 6.8%, set to be paid off in 2020 (9 years). I pay an even $200 per month on it. The private loan in my name has a principal balance of $23,162.65, fixed payment of $170.03, with a VARIABLE interest rate, currently at 3.25%, set to be paid off in 2025 (14 years). I also round up and pay an even $200 on it. The federal loan my dad took out for me has a principal balance of $10,088.70, fixed payment of $132.92, with a fixed interest rate of 7.9%, set to be paid off in 2020 (9 years). I pay an even $200 on this one as well, making my student loan payments per month $600.
I also have a car loan, outstanding balance of $8,749.88, fixed payment of $215.54, fixed interest rate of 5.4%, set to be paid off in 2015 (4 years). I pay an even $300 on my car loan, which I figure should maybe shave a year off.
My question is, should I keep rounding up on all my loans and evenly distributing a little extra to each? Or should I start with the highest interest rate first (my parents federal loan with is at 7.9% OR my private student loan rate which is VARIABLE and could fluctuate at any time). My plan was to pay off my car loan first (since its the most feasible and obtainable with paying it off quicker) and then put that $300 towards my parents loan they took out for me.
Oh, and I have a little bit over $1000 for emergencies in the bank and will be trying to be fattening up that cushion as well.
Opinions? Thoughts? Financial number crunches anyone involving the snow ball vs. avalanche? Thank you :)
Fatten up that cushion too. $1000.00 isn’t enough. Commit to $100 per month to that account and in less than a year you can double it. Try to save and pay down debt. Right now saving won’t be a great investment, the rates are awful on savings accounts. So putting that money to work by paying off debt is a good idea, but you need more emergency money. A trick I use is to round all my purchases up by a dollar. A $14.56 purchase gets logged in my accounting as $15.
Also, eliminate all late fees period. NEVER pay any late fees on bills. Pay them as you get them if you have the money.
Get on a budget by using microsoft spreadsheet. It’s easy, make a row for monthly income, another for monthly bills, and a formula that will give you a running total for the month. You can then track your spending and have your finances more up to date than the bank records. I account for every dime I spend on almost a daily basis. I am in my bank account online all the time and I caught fraudulent purchases before they were even cleared, only pending. You can also compare your bills to see if anything is out of range.
If you do this my guess is that you will find areas to cut and money that can be either saved or used for debt. Getting your savings up will ease some of the strain of being in debt. It gets a little easier when you have some cash on hand for emergencies.
I would put them in order of the highest rate to the lowest. Pay the minimum on all except for the highest rate, then pay as much as you can to the one with the highest rate. When it’s paid off, repeat the same process. You will save more in interest that way over the long run. By my quick calculations you have an extra $185 per month that you send to all the other loans that you don’t have to (not counting the one with the highest rate). If you round that up then it would be about $200 extra per month to send to your highest loan, so do that and in about 4 years you would have that highest loan nearly paid off and your car loan paid.
I would keep an eye on anything that is variable or that could change, but the guess now is that rates are going to be low for some time.
Another option is to put more money into the car loan. Student loans are a pain and everyone with any sort of education has them these days. They can be deferred and put into forbearance if times are difficult and they are not revolving credit accounts like credit cards.
Auto loans on the other hand are different and the car is gone if you don’t pay. I am of the opinion that you pay that off quickly because that loan is different. If you lose your job then you still owe the money. If your job is secure over the long haul then that might be different. That’s your assessment. Also how many miles do you put on the car, if you have a long commute they you will most likely not benefit much from paying a car off a year or two sooner, since you will be buying more frequently anyway.
Lots of factors to consider, bottom line money decision is that you pay less interest over the long term with the avalanche method most of the time. But other factors have to be looked at. Make your best assessment and plan, and then forget about it and live. No plan will be perfect. Maybe what you’re doing now is fine, what I would do might be different. Make changes if info comes up that warrants changes and evaluate your plan every so often. Sounds like you’re doing that already, But don’t get too caught up in plans about years down the road, or you will miss your life- what’s right in front of your nose.
Could this method not lower your credit rating? The old cards with low to medium balances are the ones credit bureaus look for. If they are not used for 6 months, they could show up as cancelled or even delinquent. Check some other sites about improving credit rating.
No it would not hurt credit rating. You make the minimum payments on those cards or debts that have the lower interest and pay off the ones with the higher interest first. They would not show up as cancelled or delinquent unless they were, if they do then it’s a mistake.
This is a great discussion. Thanks everyone for their input; this was one of the few intelligent discussions of various methods for prioritizing debt paydown that I found after some searching on Google. Most people just preach one system or another without really delving into the math to prove its superiority over any other system.
To me, the system that makes the most sense is computing the daily interest savings from paying down $1000 on a given loan, and prioritizing the loans that save you the most in interest per dollar of principle reduction.
For instance, we have the following debts:
$7400 at 6.5%auto loan payment 980/mo
$17000 at 3.88% auto loan payment 395.17
$17000 at 3% home equity loan payment 100
$602,000 at 3.5% payment $4300 home loan – interest tax deductible
$100,000 at 4% student loan $752/mo – interest not tax deductible as we make too much money
Basically I decided to pay off the auto loan today, which will free up $980/mo to pay more on the house, which we just refinanced from 30-year fixed at 4.75% to 15 yr fixed at 3.5%, which increased our payment $1000/mo to 4300 but doubled the principle reduction each year to $2200/mo from the current $900 or so. So essentially the extra 1000/mo from paying off the car all goes to principle on the house, which we hope will not plummet in value! Across the life of the loan we save over $300k by refinancing.
Given the tax-deductible nature of the interest on the home loan, it would probably make more sense to pay the student loan off before the home loan. But we really wanted to lock in a low rate on our biggest debt amount, and we had to go to a 15 yr loan to do that. We are also concerned that interest rates will climb and we will miss this opportunity to refi on favorable terms if we do not take it. So the student loan will have to wait a bit.
Oh well, it’s only money, right?
Thanks Again,
Karl
Sorry that should have been principle reduction each MONTH of $2200 on the house – not year.
An associate tried to convince me that the snowball method was superior to the avalanche method. He works for Primerica and they go around giving false information and fudging numbers so they can entice you to sign up for their high interest products. I tried to be polite at first but I finally called him out for giving out bad financial advice. He didn’t know I work as an accountant so he tried to get over.
We unfortunately got behind on a lot of our credit card payments, and when we finally were able to start catching up, our credit card with the highest balance (and highest interest rate) offered to settle with us. We ended up cutting this major debt in half and will have it completely paid off within two months.
This will be a MAJOR MILESTONE and has given us great motivation to keep going. In fact, after getting the “hardest” debt paid off, all of our other, “smaller” ones won’t seem as difficult at all.
Thanks for reminding us that there is more than one way to get out of debt, but the best way is the ONE THAT YOU WILL ACTUALLY USE.
Wow. I am shocked about the bad advice given to people about the most effective way to pay down multiple loans. For fun I just surfed the web and checked the advice of various experts and they were all wrong. Some say pay smallest debt first and some say highest interest rate and some say other crazy thingies. I will easily demonstrate to the reader the incorrectness of the two mentioned and then tell you how to get closer to the optimal pay down strategy.
First we must agree on what we are after. After all is said and done we want to have paid the banks less and thus keep more money in our pocket.
Here is a scenario:
Two loans:
$180,000 with 3.25% interest and 15 year term
$13,000 with 5% interest and 4 year term.
Let’s say that I have $13000 extra cash in my pocket on the start of the loans.
Following the experts advice I should just pay off the $13000 loan
(it is smaller and higher interest). This will save me all the interest on the smaller
loan which is $1370. However, if I put the $13000 toward the large low-interest loan
I pay $7662 dollars less in interest. That is about 5 and 1/2 times more money in my pocket.
It does take longer to get your money but in the end you get more. Now this was a simple
scenario but a similar demonstration is possible with a small monthly extra cash payment.
Now, I am not saying you should pay the larger loan first. If you want to figure
out how to give less money to the banks then you need to consider 1)loan amount 2)interest rate and 3) term of loan. Then go to bankrates amortization calculator and run the different
payoff schemes. They allow you to put in single extra pay off (like above), monthly
extra payoffs and yearly extra payoff. Go to the bottom of the amortization schedule and
check the amount of interest you have given the bank for each scenario. Doing this might require some real thinking as you may need to start a extra payment per month in the
middle of a term. Just record the numbers on that date and start a new amortization schedule
for the current principal and remaining term. I know you can figure that out.
You simply want to minimize the interest you pay on all the loans combined. It is actually not an easy calculation to achieve the most optimized payoff but you can get somewhat close using the calculator and running simple scenarios.
If there are tax implications from one or more of the loans you need to run the numbers completely. Most financial experts could not figure out the absolute best scheme to save their lives. So don’t beat yourself up. Mortgage calculators just are not setup to do the exact calculation you want.
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