Monday, July 30, 2012

Ask Story's money: What order to pay things off

Jenny from Tranquilamama sent me this question.

We have two credit cards. The first card is still open & we have a balance of $10,443.93 at an APR of 10.99%. The minimum payment is $199.00. 
The second card is closed to preserve the APR at a fixed rate of 5.74%. The balance is $4262.27 and the minimum payment is $64.00. 
So which one do we pay off first?

The age old question: do you pay off the loan with the lower balance or the higher interest rate?  It's a tricky one to answer, but I'm going to do my best.

The strict mathematical answer would be, always pay off the one with the higher interest rate first.  In the end, you will pay a lot less money in interest by doing that.  In theory, if you are going to be strict and keep your belts tight until you are finished paying off all your loans, you will be completely debt free sooner this way too because with less interest your payments will go further.

Real life isn't quite that simple, though.

Higher interest

Jenny has an extra $200 or so every month to put towards her debt repayments.  If she puts that money towards her higher interest loan, and then rolls the entire payment to the smaller loan once it's paid off, she is going to be finished paying off the debt in a little less time.

By my rough calculations, doing it this way will take her 80 months.  Starting with the smaller loan would take 81 months.

So it's a 1 month difference.  That's not very inspiring.

If you think about it, though - and I tried to get exact numbers, but unfortunately I don't have the time, energy or resources for that much math right now - the entire difference would come from a difference in interest.  That means, if we're talking about a total of $500 a month in payments, starting with the higher interest loan would save Jenny $500 in interest.  That's not a small amount of money.

Smallest loan

The argument for paying off the smaller loan first takes a different stance.  This argument is one that is emotional instead of logical.  

If you pay off the smallest loan first, then you get wins sooner.

If Jenny puts her entire extra payment towards her smaller loan, she can get that loan paid off in under 2 years.  This will give her a huge sense of success, and help her to focus on the larger loan.  If she did it the other way, it would take her most of the 7 years she was paying before she noticed any change at all.  It's hard to keep the faith when you aren't seeing any difference.

Also, paying off the small loan faster provides increased security in the way of cash flow.  While ideally, you will will take the entire payment from the smaller loan and put it on the bigger loan, not having that payment every month is really important should you be met with an emergency.  In theory, this means you can keep less in your cash reserve too, thus having more to pay towards your loans.

The verdict

So, my very official answer is, it depends.  If you are very logical and mathematical, and trust yourself to keep at it, you really will do a little better by starting with the higher interest loan.  In the real world, however, most people will do better by starting with the smallest loan.  If the difference in interest were larger, the psychological boost might not be worth it, but really they are very close.

Also, hopefully seeing the progress will motivate you to put even more money towards your credit cards, paying it off even faster.  The faster you pay it off, the less the interest rate matters at all.

As a final thought, either way you choose to do it is fine as long as you DO IT.  Proud of you, Jenny, and the rest of you dear readers, for making the decision to do this.  You are doing great.

Got questions?  Please?  Leave them in the comments or tweet or email them to me, and I'd be glad to answer them!