Imagine this: you have a list of things you have to do today. Some of those items are large projects that will take some time. Others are small and can be completed quickly. You need to get them all done.
Which do you start with?
Are you the type of person who tackles the big projects first? You feel it’s good to get them out of the way and it gets easier after that.
Or are you the type of person who tackles the little ones first, getting satisfaction from being to cross off items on your to-do list early and often?
Well, this conundrum is similar to deciding which debt to pay off first that will help you get out of debt fastest.
For all of us, this is one area we delve into the world known as “behavioral economics”. That is, we don’t always act rationally when it comes to money.
When people look at their credit cards, auto loans, school loans, mortgages, etc., the most common question is which one do I pay down first?
Paraphrasing Smokey the Bear, only YOU can answer that question.
As a general rule of thumb, any debt where the interest is tax deductible should be paid off last. This would include student loans and mortgages. Why? Because this debt doesn’t cost you as much because the interest helps save money on your taxes.
Otherwise, they are six ways you could prioritize:
1. Highest interest rate
2. Highest balance
3. Lowest balance
4. Largest monthly payment
5. Smallest monthly payment
6. Lowest number of monthly payments remaining
An example: In 2007, I worked with a husband and wife in NH, 2 kids, both white collar professionals. They had the following:
Credit cards - $20k balance, rates range from 9.49% to 29.24%
Auto loan - $3k, 11%
Retirement plan loan - $1k, 5.7%
Student loans - $145k, rates range from 2.88% to 11%
Mortgages / equity line - $219k, rates in the 6% range
In all, $375k in debt, with required monthly payments of just over $3,300 per month for everything.
On top of that, they were paying $365 extra per month, spread throughout the different loans.
Which order of priority do you think led to the most favorable results?
Using the debt stacking method with the different priorities:
Highest rate – Total interest paid - $231k, time to pay off – 34 yrs, 2 mo
Highest balance – Total interest - $268k, time – 35 yrs, 4 mo
Lowest balance – Total interest - $224k, time – 31 yrs, 8 mo
Largest monthly payment – Total interest - $234k, time – 36 yrs, 7 mo
Smallest monthly payment – Total interest - $258k, time – 30 yrs, 1 mo
Smallest number of monthly payments remaining – Total interest - $248k, time – 38 yrs
Did you guess correctly?
If we were all completely rational, we would all start with the lowest balance first. That leads to the smallest amount of interest paid over time. But if you prefer time over money, you would choose to start with the smallest monthly payment.
And some people choose a completely different order for any number of reasons.
The specifics of each loan (balance, payment, interest rate, etc.) would change the order so what these people did may not work for you.
Looking at their situation, which method would you choose?
Looking at your own situation, which method do you use?
Answer to last week’s trivia question – D – George W. Bush. Yes, in January 2007 then President Bush declared that within 5 years, the budget deficit would be zero. So much for predictions…
This week’s trivia question: According to the IRS, an analysis of 2006 tax return data (after audits) indicated that people only paid what percentage of their actual income tax bill. Is it?
A – 100%
B – 92.5%
C – 85.5%
D – 51.6%
