Strategies to Pay Down Your Debt
Let’s suppose you are a married couple, Jessica and Michael. Both of you are thirty years old. Big purchases, on which you owe money, include a house, a car for each of you, student loans, furniture for the house, which you have put on your unsecured line of credit, and other items like food, clothing and miscellaneous expenses, which you have put on your credit cards. Laid out in a table, the debts and debt repayments look like this:
Even though you are both making enough to comfortably pay your debts, you would like to begin having children in the next couple of years, and to prepare for that event you want to reduce your debt to a more manageable amount. Frankly, owing more than half-a-million dollars freaks you out. You had been building up an emergency fund, and now that you have set aside six months of living expenses in a savings account, you are ready to redirect that money toward paying down your debt. Which debt should you tackle first?
Looking at the list, your initial response is to start with the mortgage on your house. It’s the largest figure and has the biggest payment. But that feels discouraging because even if you put an extra $1,000 per month onto your mortgage payments, it’s not going to make that much of a difference.
You look further down the amount owing column and you see that your line of credit has the lowest amounts owing. Maybe you should direct your extra payments there first. That gives you some satisfaction, but you are not sure if that is the best choice. Besides, you don’t have a deadline at which you have to pay it off, so what’s the rush?
Then you look at the interest rate column and see that the credit cards charge the highest interest rate so you wonder if that should be the most important factor.
Finally, you look over to the monthly payment column and see that Jessica’s student loan has the lowest monthly payment of $232.33 per month so you think that maybe you should pay that down first.
How do you make the best choice on which item to pay off first? There are two choices that are often touted among personal finance experts.
The Psychological Approach: The Debt Snowball
Advocates for the Debt Snowball argue that the most important thing to do is to get started on paying down your debt and feel good about having accomplished something. There is certainly some merit to this point. As has been pointed out repeatedly in recent years, we humans are not perfectly rational with respect to money. We often make choices that feel better to us, even if they are not the most efficient. Reorganizing the list of Jessica and Michael’s debts, below in Table 2, is the priority in which the list of debts should be attacked. If they choose to simply continue the minimum payments, which in this case is 2 percent of the amount owing, the payment in the first month is $260 ($13,000 x 2%), as shown below. Continuing at $260, it takes nearly 6 years (58 months) to payoff the line of credit. If instead, this couple chooses to pay $1000 per month, they could pay off the line of credit within 14 months.
Why is this method referred to as a “snowball”? If you recall making a snowman in your yard as a child (or with your child), a snowball typically starts quite small. As you roll it around the yard, it accumulates more snow. Eventually it gets quite large and you have accomplished your debt payoff task.
The Rational Approach: The Debt Avalanche
While paying down a loan that charges 6% interest is much better than accelerating payments on Jessica and Michael’s student loans, car payments or mortgage on their house, the interest rate charged on the credit card should be a red flag alerting you to very costly debt. Table 3, below, lists the priority for debt repayments on a Debt Avalanche basis.
Let’s assume that Jessica and Michael do not add any more debt to their credit cards. They start off with their balance of $17,000 and their first monthly payment of $510. If they just keep on making their minimum payments, which is no doubt an attractive option, it will take them over 28 years to pay down their debt to zero. If instead, they put $1,000 toward their credit card debt each month, it will be fully paid off in 1 year and 9 months. How much of a difference would that make in terms of interest paid? Over $20,000.
A “Debt Avalanche,” as the imagery suggests, is a means of payment which very quickly builds up the amount of the debt repayment. In my mind, it is as though this approach to payment overwhelms the debt owed at a surprising pace. Until Michael and Jessica pay off their credit cards, they will continue to make minimum payments on their line of credit. Once the credit card balance is down to zero, they will carry on with the line of credit and follow that with Michael’s car loan, etc., until everything is paid off. Despite the huge size of the mortgage, it turns out that paying off the house is the last place where they should be putting their surplus money to pay off their debts, because the mortgage carries the lowest interest rate. However, once the higher interest loans are paid off, there will be a lot more freed up cash that can be applied to the mortgage.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.