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What Debt Should You Pay
First?
Smallest Bill? Or Highest Rate?
The Dollar Stretcher
by Gary Foreman
gary@stretcher.com
My husband and I have accumulated some credit card debt, a personal
loan
from my mom, and a home equity line of credit. Recently getting
married,
purchasing our first home, and some medical bills have really put a
hurting
on our budget. Some advice that I have read says that one should
pay off
the debt with the highest interest rate first. Other advice says to
pay
off the smallest debt first and work my way up the debt ladder.
Which one
is the most effective in our situation?
Amy
According to the Federal Reserve currently there is over $1.7
trillion in
consumer debt. So an awful lot of people are facing the very same
choice.
So let's see if we can figure out what would work best for Amy.
Paying the debt with the highest interest rate will reduce the total
debt
quicker. The reason is clear. The higher the interest rate, the more
interest is added to the balance you owe each month.
Suppose you owed money on two different accounts. The first account
charges
5% interest. Paying off $1,000 would save Amy $4.17 per month in
interest
expense ($1,000 times 0.05 divided by 12 months).
Now suppose the second account charges 10% interest. Paying off
$1,000
would save $8.33 per month. Clearly, she'll save more, and reduce
her
balance quicker, if she pays off the account the highest interest
rate.
But, there is a risk to this strategy. It might take Amy quite
awhile to
pay the entire balance of the account with the highest interest.
And, after
6 or 8 months of trying she might get discouraged and be tempted to
give up
if she's still writing a check to them each month.
Let's face it. Some people are more determined than others. And some
of us
need immediate feedback or gratification.
One way to get that positive feedback is to have an account
disappear
because it's be entirely paid off. The fact that it's the account
with the
smallest balance doesn't matter.
What's best for Amy? Paying off the highest rate of interest first
is the
most efficient answer. But depending on Amy's personality, paying
off the
one with the smallest balance might be the best answer.
Before she decides, there are other ways to get positive feedback as
you
pay down debts. One simple way is to watch your total indebtedness
drop
each month. Just list the balance on all your accounts and add them
up.
Then compare the totals after a few months. Notice how the mountain
of debt
is getting a little smaller. If Amy is into visuals, she could keep
a
running graph of the total.
Another way to encourage yourself is to watch the amount of interest
owed
drop each month. Remember that the interest you owe each month
doesn't buy
you anything. It's the price you pay for borrowing the money some
time in
the past.
Just list the interest charged by all of your accounts and total it.
Again,
compare it to the total from a few months ago. If the total amount
owed is
going down, so should the amount of interest that you pay each
month.
Watching her balances drop might not be enough for Amy. She might be
one of
those people who won't feel successful until she's writing fewer
checks
each month. If that's the case she should pay off the smallest
account
first so she feels like she's making progress.
Amy will probably find that her most expensive debt is on credit
cards. The
least expensive will be her mortgage. If she's sure that they don't
have a
problem with uncontrolled spending, they might even want to use a
home
equity loan to pay off some higher interest debt. But only if
they're not
"spendaholics".
One other strategy would be to pay off one or two of the small
accounts to
get started. Once Amy is past the point of needing encouragement she
can
shift to paying more on the accounts with the highest interest.
Finally, it's more important that Amy starts now than which account
she
pays first. Each month she delays all of the accounts add to the
interest
owed. The hole gets a little deeper. It's better to pay off low
interest
debt, than no debt at all.
_____________
Gary Foreman is a former financial planner who currently edits The
Dollar
Stretcher website <www.stretcher.com> You'll find thousands of
articles to
help you stretch your day and your dollar. Visit Today!
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