Thursday, September 10, 2009

Paying off Debt

Everyone always talks about how important it is to get out of debt. Let me highlight how it will effect your pocketbook.

Let's make some assumptions:

$1000 on credit card A with an interest rate of 7.9%

$2500 on credit card B with an interest rate of 11.9%

$10000 on an auto loan for your car at 4.99%

Your situation may be different, with varying interest rates or amounts. If you are not in debt, I applaud you! Try to stay that way!

Going back to the example..

What is your first inclination on how to approach paying the debt off? Do you want to pay off the highest amount first or the highest interest rate?

Well you can't go wrong either way, because you will still be paying down debt, but the best choice would be to pay down the highest interest rate first. It will take you longer to pay off the higher interest rate card in this example, rather than starting with the lower balance, but you will be paying less interest overall.

Interest saved = money back in your pocket!

If you do nothing but pay the minimum on the above example, you will end up paying for the tanks of gas, new clothes, and cell phone bill you put on your credit card for a ridiculous period of time. This will keep you from achieving your financial goals and should be avoided.

Your credit card debt alone in this example will take over 8 years to pay off if you only pay the minimum (used a 4% minimum payment). That's a long time to pay for a slurpee/starbucks habit.

If you can add $100 dollars to your total debt paydown each month, and apply it to your highest rate card, you can reduce the amount of interest you pay significantly. Here are the steps to pay down debt faster.

1. Apply your extra $100 to your highest rate card (along with your usual minimum payment) ; continue to pay your other minimum payments.

Using the above example it would be highest rate 11.9% minimum payment = $100 so increase your monthly payment to $200.

2. Once you pay off your highest balance card, apply both the $100 dollars and the old minimum payment to your next highest balance card. Keep paying all of your minimum payments.

This would mean now we are paying the next highest which would be 7.9% minimum payment around $40. Add your old minimum from the old card plus the extra hundred you are using to pay debt down early.

$40 + $100 +(old minimum which would have gone down with a lower balance.)

3. Move on down your debts and continue with your plan.

By doing this, you could pay off your debt in around two years instead of eight.

Now what to do once you've paid off the debt? That's next! Until then, think about what you will do when you are debt free!

PS: Bonus, you will save over $1000 dollars in interest by paying it off early :D


  1. Logically that makes perfect sense. I read on that paying off the smaller amount first shows you that there is a light at the end of the tunnel (for those that have a long tunnel to go). That light at the end of the tunnel gives you the motivation to finish paying everything off, even those higher debts. Maybe in the long run, it's not financially the best choice, but it could be the motivation that some need.

  2. P.

    Thanks for the comment! That is a perfectly good alternative, and still meets the goal of motivating someone to start paying down their debt faster. I'm all for it, it just wouldn't reduce your interest payed as much as the other method.

  3. Jon- your advice is right on the money!! We got the same advice from the budget counselor we went to a few years ago.

    We started out paying our smaller balances so we had some sense of accomplishment and to see the "light at the end of the tunnel". It's taken a good 3 years but we're finally almost out of debt, only about $2500 left to go!!! and it's an amazing feeling considering where we started out at.

  4. Thanks for stopping by! I'm glad you guys are close to your goal of getting out of debt. What a weight off the shoulders!