The best way to pay off debt
There is one mathematically correct way of paying off what you owe, but it doesn't work well for everybody.
This post comes from Brandon Ballenger at partner site Money Talks News.
American households with credit card debt owe an average of $15,799, according to CreditCards.com.
While people have a hard time dealing with debt, they also have a hard time talking about it. Another interesting (and weird) statistic from CreditCards.com is that Americans would rather discuss their salary, weight, politics, or religion with a stranger. They found that the only topic of discussion rivaling debt as a taboo was "details of your love life," with only 19% willing to discuss.
And if people can't talk about debt, maybe that's why new research shows most of us take the wrong (or at least more expensive) approach to paying it back -- paying off the smallest accounts first. Or is there another reason? In the video below, Money Talks News founder Stacy Johnson explains the research behind the psychology of debt management, including why people often use this strategy. Then read on for more on how to tackle debt.
As Stacy said, the most important part of tackling debt is motivation. If you aren't going to make consistently paying down debt a priority, you lose out regardless of strategy. So while there is a clear, mathematically correct approach to dealing with debt, it's important to do what works best for you. Here are the two common approaches:
Prioritizing high-interest accounts. In this model, you make the minimum payment on every debt except the one with the highest interest rate, which is the one costing you the most money over time. For that debt, you throw in whatever you can regularly afford beyond the minimum until it's paid off. (Do you have too much debt? Check this calculator.)
Once that debt is gone, your debt-paying budget stays the same. You just shift the higher payment to the debt with the next-highest interest rate, and go on down the line.
The obvious advantage to this model is you save the most you can over the long term. The downside: Progress may appear to be slower than it actually is. Having a large number of debts may feel more stressful than the fact you're throwing more money at the most-costly debt.
Paying off low balances first. As with the first model, you pay the minimum on all but one debt and "snowball" the payments from one debt to the next as they disappear. The difference here is that you focus on the smallest debts, allowing you to knock accounts off the list faster.
The advantage? Having fewer accounts to juggle feels good. It's a result we can easily see: Numbers shifting downward is not as impressive or obvious as a big zero. Unfortunately, this means you're actually making slower progress on your overall debt because those big-interest accounts are accruing.
Is this hard to visualize? Think back to sixth grade and the mathematical order of operations: Multiplication and division (i.e., percentages) come before addition or subtraction (i.e., payments). Or look at it this way: You're trying to bail out your sinking ship, but a bunch of creditors are standing behind you with little kiddie beach pails, pouring more water in. While it may feel good to turn and shove those guys off your boat right away, there's a jerk with a huge bucket standing -- and grinning -- at the other end of the ship. You really ought to run and tackle him first.
How to decide on the best approach
The fact is, the bucket sizes are different for everybody. We all have different situations, with a number of debts of varying sizes and interest rates, and with different income levels. Fortunately, there's a much more concrete way to figure out how to handle debt that works for everybody. Being able to plug your specific numbers in can help you decide.
Check out Unbury.me, a clean and easy-to-use calculator that can test both methods with your input. You can add as many loan balances as you want and you'll get back a graph and payment breakdown, along with total interest paid and a debt-free date. You only have to plug the numbers in once, and you can switch between "avalanche" (high-interest style) and "snowball" (low-balance style) with one click.
I’ll give a personal example I ran through the site, which I guess puts me in that 19% who disclose debt details. I have three subsidized grad student loans that look like this:
- $7,970.92 -- $95 a month minimum, 6.8% interest.
- $1,131.53 -- $50 a month minimum, 6.8% interest.
- $6,799.07 -- $80 a month minimum, 6.3% interest.
I currently put about $300 a month toward these and hope to increase it as time goes on. But at the current rate, with the high-interest approach, I'll be done in September 2016 and will have paid an extra $2,855.86 beyond the outstanding loan amounts. With the low-balance approach, I'll be done by October 2016 with an interest bill of $2,924.83. The difference is just $69 for me because my interest rates are not far apart. (Will you be able to pay off your student loans? Try MSN Money's calculator.)
Because that's a small difference (and because some student loan interest is tax-deductible), I don't really care. I'll opt for the low-balance approach like most people, and pay off that small loan by next May instead of by August 2013. It's one less thing for me to keep track of, for about the cost of one monthly payment.
Your situation could be very different, though, and that's the value of the calculator. Try your numbers and see what makes sense to you.
More on Money Talks News and MSN Money:
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