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!

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Ask story's money: Budgeting for variable expenses

My first question for Ask Story's Money comes from my good friend Elizabeth who blogs at She Likes Stripes:

I definitely still need help with budgeting, like how do you know what your monthly gas budget is? or groceries? Coming as someone who has no budget set right now (and I suppose that's probably also due to the fact that i'm coming off of 4 years of living alone) ... how do you set those numbers when you're pretty sure you already spend too much? ... Or how do you allow yourself little treats (like new shoes here and there, things for fun) amid trying to be super frugal because you know you have big things to save up for?

The first step to budgeting for variable expenses like this is to know how much you already spend. There are various software and online solutions for this, but for me the easiest way is just to sit down with your credit card or bank statements and start adding. Depending on how much time and patience you have, you can do one month or do three months and average them.

Odds are, the first time you do this exercise, you will be a little horrified. Most people have no idea where their money is going.

So how do you figure out how much you "should" be spending?

1. You can look at the national averages or recommended percentages for grocery budgets. Unfortunately I think this is probably the least useful
way to do this because there are so many variables at play.

2. You can figure out how much you can actually afford to spend. This requires you to really sit down and make a full household budget, listing all your regular expenses and your income. If you are currently spending more than you can actually afford to in a sustainable way, this is crucial.

3. You can set incremental goals. For the most part, I think this is where most people should be. Try to gradually reduce your grocery spending a little bit every month until it reaches a point at which you feel more comfortable.

How to actually reduce this? Is a much bigger question and one for another day.

Have a question? Leave it in the comments or send me an email.

I need your help

When I started this blog, it was to help me get my mind around my money. We didn't have much, and I had to work hard to make the numbers work, and I had so much to learn.

Then at some point, I didn't have so much to learn anymore, and so I got bored. I felt like I was repeating myself, like it had all been said, like anything I wrote on here was just so obvious.

But now I'm realizing it's only obvious to me.

In the past few days I've had a few really dear friends tell me that some money advice I gave them - which after all these years seems intuitive to me - was life changing. And I can't think of anything more gratifying. So I would like to start writing here again, and to use this blog as a vehicle for sharing what I've learned and what I know, for helping other people to get their money under control. And to be perfectly honest, I could use it too, to get my fired up again and make some real progress on our money goals.

But I need your help. Because I don't know what to write. So here's what I need from you:

• Questions - what do you need to know about money? We can have an "Ask story's money" feature, or a longer series on specific issue.
  
• Challenge ideas - want to do a challenge with me? Like a grocery challenge, or an extra income challenge, or a savings challenge?
  
• Guest posts - Got a financial success, or even a problem, you want to write about? Send it over.
  
• Any other ideas for what to write about?
  

Let's get some pep back in this blog and talk about our money.