A good strategy could help you pay off your debt earlier. To devise an effective strategy you need to first understand a few key concepts.
- If you pay off the debt with the highest interest rate first, you will save money on interest.
- If you pay off small debts first, you will be more motivated to continue pursuing your financial discipline.
- Reallocating debt to another creditor with lower interest rate, such as through balance transfer, can save you money on interest.
- You don’t have to pay off a very low interest loan whose interest is less than your investments
- Calculate the effects of inflation before paying off debt
- If you have too many debt instruments, reducing them would help improve you credit score and reduce you overall interest in the longer term
It is common sense that you should always pay off the debt with highest interest rate first. Suppose you have $15,000 debt on a credit card with 30% interest and another loan of $15000 at 10%. The interest on the credit card will be $5173 over the year and $1571 on the lower interest loan. If you payoff $5000 off the credit card, your interest would be reduced to $3445. If you pay off $5000 from the lower interest loan, your interest would be reduced to $1047. That is a difference of $2398 of additional interest savings between the two loans in one year.
We often get ourselves into financial difficulties by being emotional rather than logical. This is why it might make sense to pay off smaller debts first, even if they are lower interest loans. This is because every time you pay off a debt, you will feel a sense of winning, a sense of gaining back control over your finances, and you would be more motivated to pursue your cause of debt reduction rather than being complacent. Which is why some people advise paying off small loans first.
Some credit cards offer low interest balance transfers. If you have existing purchase balance on a credit card, do not use it for balance transfer. Instead pay if off first and then use the balance transfer interest rate. Otherwise, your payments will not affect the high purchase interest and will be used towards the lower interest balance transfer. If you stand to benefit from a low interest balance transfer, then pay off that card first and then transfer the highest interest debt into that card.
Suppose your investments are earning you 6% annually while your line of credit is only charging 4% interest. In this scenario, it makes more sense to add more to the investment, rather than paying of the lower interest loan.
Don’t forget inflation. It can be your enemy or your friend. Suppose you purchased a vehicle for $30,000 at 3% interest with $0 down. Let’s assume that the annual rate of inflation is 3% as well. Does it make more sense to pay off the vehicle in 5 years or 7 years?
Note that vehicle loans are generally simple interest loans rather than compounded interest loans. If you pay off in 5 years, you will pay $2343 in interest. If you pay off in 7 years, you will pay $3286 in interest. However a monthly payment of $396 is equivalent to a payment of $441 in 2017 because of inflation. Over the last 2 years, you save $1000 in 2017 money which is equivalent to $900 in 2010 money. If you pay off your vehicle in 5 years, you save $900 in interest but if you pay off the vehicle in 7 years, you save $900 from inflation over the last 2 years and you end up with smaller payments over the duration of the vehicle.
If you have too many credit instruments, then you need to think about reducing them because this negatively impacts your credit score. In this situation you should also figure out what strategy balance paying off highest interest rate debt against the need to close some of the credit instruments available to you.
When it comes to devising a debt reduction strategy, there is not one side fits all strategy. The best strategy depends on your individual situation and your ability to maintain the discipline to keep paying off the debt. Consider the 6 points mentioned here and talk to a reliable financial advisor to help you achieve your debt reduction goals.
