Monthly Archives: February 2016

Comparison of different debt repayment strategies

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:

Name Amount Rate Minimum Payment
Car Loan $10,000 5% 100
Credit Card $24,000 15% 480

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?

Name Time Interest Total Cost
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:

Name Time Interest Total Cost
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:

Name Time Interest Total Cost
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.

Conclusion

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.

Children Should Know The Cost Of Borrowing

Where I Came From

mother-child 2

When I was a child my parents were fiscally responsible.  They paid their bills, avoided debt, and conserved wherever they could. Despite having an average income they were able to eventually pay off their mortgage and gain some financial independence.

You may think this translated into a child who also had good financial habits, but unfortunately for me, that isn’t the case.  I struggled with excessive debt and poor budgeting well into my 20s.

During many of the most difficult times I found myself wondering exactly how I got into such a mess.  The answer came to me many years later. I had to have a few close calls with disaster, stand on the brink of financial ruin, and talk to a lot of smart people before I became open minded enough to really look for a solution.

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Ally adds Touch Id login feature to iOS app

A recent release of the Ally app for iOS has solved one of my biggest gripes with it – lack of Touch ID authentication. This allows you to login to your account with just your fingerprint, and makes logging in on a mobile device a lot easier.

My old bank – Capital One 360 – had this feature in their app for some time and I really missed it when I moved to Ally. You’d think it is a really small thing, but it is pretty handy to have. The only thing to consider is that if you allow Touch ID to unlock your bank account, anyone who can login to your phone can also login to your bank account – so be careful with it.

New features like this are one of the reasons Ally continues to be rated highly by those who use it.

My favorite personal finance book

Semit Rethi’s I Will Teach You To Be Rich is the best personal finance book I’ve found, and it’s the one I recommend to people who are starting to get their financial house in order, are new to investing, or are in their early 20s. If you’re older and are already in good shape financially, this book will be less useful.

Sethi’s book is a fairly easy read – it’s only a few hundred pages of easy-to-understand information, written in a pretty informal tone. He first explains credit cards and credit scores, and talks about things you can do to get fees waived, optimize your credit cards, and avoid falling into the trap of spending a lot of money on interest every month.

Next, he talks about finding a low-fee, high-interest bank account to keep your money in – in an era with low/no fee accounts that pay around 1% interest rates (at the time of this writing, at least), it is amazing how many people continue to pay unnecessary fees at banks that offer negligible interest rates (as a side note, our site – Best Savings Rates – can help you find the best place to keep your money).

Then, he tries to demystify investing. Investing your money wisely is the easiest way to become rich over time, but it is confusing for many people and it is easy to invest in ways that aren’t optimal. For years, I invested in individual stocks and watched as I paid lots of money in commissions, only to see less of a return than if I’d just stuck it in a boring index fund.

The section on investing is probably the most useful and important for people starting out – the sooner you start investing wisely, the more money you’ll have.

Sethi also goes over tracking your expenses (which is really important – how else will you know where you are spending more money?) and tries to keep things in context – rather than making you feel guilty for a latte here and there or eating out a lot, he tries to get you to focus on the important things.

The only things that aren’t great in this book are: 1) His examples of high-interest accounts are out of date, and 2) his advice about negotiating a car deal isn’t very good. Don’t follow it.

Overall, this book won’t make you rich quickly, but it will teach you how to save and invest your money wisely, so that you will be rich at some point in your life. It is available for less than ten bucks at Amazon, and I highly recommend it.

Best online savings accounts of January 2016

Best Savings Rates tracks online savings accounts, shows the ones with the highest interest rates, and collect reviews from users of those accounts. This is a summary of the best banks track by Best Savings Rates in January 2016.

Best Interest Rate

CIT Bank and Ally tied, both offering 1.0% APY. The median interest rate offered by banks tracked on our site was .65% APY, and the mean rate was .52%, so both of these banks are well above-average in that regard.

Best Overall Rating

The best overall ratings went to Ally (4.8/5.0 stars) and Discover (4.7/5.0) stars – both of these banks were given consistently high ratings by customers.

Best Customer Service Rating

We also gather feedback on customer service satisfaction – the winners of those were Citibank e-Savings (4.7/5.0 stars) and Ally (4.6/5.0).

Overall Winner

The “Best Savings Account for January 2016 from Best Savings Rates” goes to Ally – they were tied for the highest interest rate and received consistently good reviews from customers. Congrats Ally!