As discussed in my last post, you can find all sorts of information
about what order you should go in. Many people swear by paying off the highest
interest rate first, and others say smallest balance first.
Before we dive into which one is best, let’s take a moment with a
few questions:
1. True/False: Paying
extra on loan payments results in paying off loans faster?
2. True/False: Paying
extra on loan payments results in paying less in interest overall?
3. True/False: Paying
extra on loan payments is “worth it”?
The answers for #1 and #2 are both true. The answer for #3 is I
HAVE ABSOLUTELY NO IDEA! And neither does anyone else. It is different for
everyone.
What does “worth it” or “best” mean to you? Do those terms mean
saving the most interest? Or do they mean paying off debt in the shortest
amount of time?
Getting back to the order, there’s actually 6 ways you could
prioritize debt.
1. Highest rate
2. Smallest balance
3. Largest balance
4. Smallest monthly
payment
5. Largest monthly
payment
6. Fewest payments
remaining
And in my experience, one method typically leads to the least
amount of interest paid, but a different method results in the shortest payoff
time. This is still using the debt
stacking method I wrote about last week.
In one case, a couple with over $110k in debt between credit cards,
car loans, and a home equity loan, their results were as follows:
|
|
Best Method
|
2nd Best
Method
|
|
Lowest Interest Paid
|
Lowest # of Pmts
|
Largest Balance
|
|
Shortest Payoff Time
|
Highest Rate
|
Largest Monthly Pmt
|
On the other hand, another couple with a similar amount of debt,
though mostly in student loans and only some credit cards, the results were
quite different:
|
|
Best Method
|
2nd Best Method
|
|
Lowest Interest Paid
|
Highest Rate
|
Smallest Mo Pmt
|
|
Shortest Payoff Time
|
Lowest # of Pmts
|
Highest Rate
|
What is true is that in both cases, the “cost” to go with the 2nd
best method instead of the first was very small. Either it only led to a small
amount of extra interest or time, but clearly, the “highest rate” or “smallest
balance” aren’t always the best answers.
Another interesting point about this: by
adjusting how much you pay, it doesn’t affect the interest paid or payoff time
that much. Conversely, when you take away that extra
money, you don’t lose that much time.
For that first couple, taking away all of the extra payments ($350/mo
- meaning they were only paying the minimum on all of their debt), that
only added less than 2 years of time and about $6k in extra interest (on over
$100k in debt).
For the second couple, cutting their extra payments in half (from
$500 to $250/mo) meant less than 1 year of time and $3k in interest cost.
Think about this. You can cut your monthly
payments on your debt and not cost that much. What would you have to give up in
your lifestyle to free up the same amount of money each month?
If you have debt, what is your optimal order? And if you’re making
extra payments, how much are you really saving in time and money?
By the way, being debt free doesn't really mean being debt free. But that's a later post...
