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Smallest Bill? Or Highest Rate?
by Gary Foreman
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 "spend-a-holics".
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.
About the author
Gary Foreman is a former financial planner who currently edits The
Dollar Stretcher website
http://www.stretcher.com You'll find thousands of articles to help
you stretch your day and your dollar. Visit Today!
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