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
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.
Gary Foreman is a former financial planner who currently edits The
Dollar Stretcher website <www.stretcher.com>
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