Best Strategies for Paying off Debt Quicker
October 11, 2010
Suppose you’ve made the required payments on all your loans and want to use some extra money to pay off your debt quicker. How do you choose which loan to pay off first?
There are two main strategies for accelerating the repayment of debt. One involves paying down the loan with the highest after-tax interest rate first. The other, popularized by Dave Ramsey as the “debt snowball plan”, pays off the loan with the lowest balance first.
The snowball technique for paying down debt is only appropriate when you lack the motivation to pay more than the minimum balance on your loans. Tackling the loan with the lowest balance first will give you measurable progress toward eliminating your debt because you will pay off one of your loans sooner. Dave Ramsey argues that a “quick win” will help keep you motivated to pay off all your debt.
But this strategy will keep you in debt longer and will cost you more interest over the life of the loans as compared with the other strategy. Watching your loan balance decrease should be enough to keep you motivated.
Making extra payments on the most expensive debt first will minimize the total interest paid over the life of all your loans. The most expensive debt is the debt with the highest after-tax interest rate, usually credit card debt and private student loans.
Consider two 10-year loans, a $10,000 loan with a 15% interest rate and a $5,000 loan with a 5% interest rate. The required monthly payments on the two loans total $187.85. If you do not make any extra payments on the loans, the total interest paid over the 10-year term will be $10,042.16.
If you follow the snowball plan and make an extra payment of $50 a month on the smaller loan first, that loan will be paid off in 36 months and the second loan in 91 months. The total interest paid over the life of the two loans will be $7,558.66, saving you $2,483.50. Not bad.
But if you target the higher after-tax interest rate loan first, that loan will be paid off in 73 months and the other loan in 88 months. Not only will you have paid off all your loans sooner, but the total interest paid over the life of the two loans will be $5,830.40, saving you $4,211.76. Thus making the extra payments on the highest cost loan first saves you an extra $1,728.26 as compared with the snowball plan.
Either method will save you money by paying off the debt sooner, but targeting the highest after-tax interest rate loan for extra payments first will save you more money.
Similar insights also apply to choosing whether to invest the extra money or pay off debt quicker. If your after-tax return on investment is higher than the after-tax interest rate on your most expensive debt, you should invest the extra money instead of accelerating repayment of your debt. For example, in most cases you should maximize the employer match on your retirement plan contributions first because the employer match is free money. On the other hand, if you are earning 2% on a savings account and paying 14% on your credit cards, you should use the savings (except for 3-6 months salary in an emergency fund) to pay off the credit card debt. Paying off the credit card debt will save you more money than you were earning in your savings account because it will help you avoid paying the higher interest rate on the credit card debt. Of course, you should do this only if you can resist the temptation to run up the balance on your credit cards again after you’ve paid off the debt. Cut up the credit cards if necessary.
Some people argue that you should never accelerate repayment of very low interest rate loans and instead should stretch out the repayment term as long as possible. For example, borrowers of federal student loans were able to lock in interest rates as low as 2.88% in May and June 2005. These borrowers are unlikely to obtain such a low interest rate ever again and can earn a better return on their money by investing it. Still, there’s a great sense of freedom from not owing anybody anything. Sometimes the psychological boost of being debt-free is worth the cost of the lost opportunity to squeeze a few more dollars out of your personal finances.
You are the best judge of whether you need extra motivation to stick to a repayment plan that pays off your debt sooner. But targeting the highest interest rate loans for extra payments first will save you money.