Scientific American recently asked, why don’t people manage debt better? It is a really good question, and the article does a good job of showing how people make seemingly-irrational decisions about how to pay down debt. The authors argue that the most optimal way to pay down debt is to use extra money to pay down the debt with the highest interest rate first – and they are correct in stating that it is the most mathematically optimal way to do it.
It isn’t the only, way, though and there are some good arguments that the mathematically optimal approach may not be optimal for other reasons. The “Snowball” approach, popularized by Dave Ramsey, is another approach that works well for a lot of people – it is less optimal from a mathematical perspective but more optimal from a psychological perspective in a lot of cases, and that is important.
We’ll compare 2 methods of paying debt down more quickly – paying the highest interest rate first, and the snowball method. This comparison assumes a few things – 1) You have more than one debt, 2) You have at least $1 beyond the minimum monthly payments to pay down your debts more quickly, 3) You aren’t accruing new debt.
Let’s assume you have 2 debts:
Now, let’s assume you only pay the minimums. How long will it take to pay them off and how much will you end up paying?
|Car Loan||10 years, 10 months||$2,963||$12,963|
|Credit Card||6 years, 7 months||$13,899||$37,899|
You end up paying $16,862 in interest, or $50,862 total on an initial amount of $34,000.
Now, let’s assume you have an extra $250 per month to apply to your loans, and when you finish paying on one, you’ll apply the payment you were paying before to the remaining one.
1. Paying the highest interest rate first
In this method, you pay $730 per month on the credit card until it is paid down while paying only $100 on the car loan, then when the credit card is paid off, you apply the $730 per month to it for a total payment of $830 per month. Here is what that looks like:
|Car Loan||4 years, 4 months||$1,710||$11,710|
|Credit Card||3 years, 7 months||$7,103||$31,103|
Your debt is paid off after 4 years and 4 months, instead of almost 11 years. You pay $8,813 in interest, or $42,813 total on an initial amount of $34,000. This is the most optimal way to pay the debt down, from the perspective of paying the least amount of interest.
2. Snowball (pay the one with the lowest outstanding amount first)
In this method, you pay $350 per month on the car loan until it is paid down while paying only $480 on the credit card, then when the car loan is paid off, you apply the $350 per month to it for a total payment of $830 per month. Here is what that looks like:
|Car Loan||2 years, 7 months||$669||$10,669|
|Credit Card||4 years, 8 months||$9,609||$33,609|
Your debt is paid off after 4 years and 8 months, instead of almost 11 years. You pay $10,278 in interest, or $44,278 total on an initial amount of $34,000. You end up paying $1,465 more with the same set of parameters, except which debt you pay off first.
$1,465 is no small chunk of change. So, why would you consider this method? There are two reasonably good reasons:
a) The psychological effect. For a lot of people, making more progress on a smaller debt may motivate them to stick to their plan to pay off debt and increase the likelihood that they will be successful. If that is the difference between sticking to a debt repayment plan and not, then the $1,465 is a small price to pay.
b) There is another benefit in that in a shorter amount of time, you get some more free cash flow ($100 per month in this case) that can be used to absorb other unexpected expenses and help you avoid getting into more debt. In this case, we get more cash flow after just two and a half years, versus over 3 and a half years for the more optimal solution.
The method you use is largely up to you – do you value saving the most amount of money, or is the psychological effect of a quicker win more appealing? The important thing is you make a plan and stick to it, and that you are aware of the tradeoffs of each method.