The following piece is courtesy of Wixx and our satellite site Debt Reduction 101. Although some argue that your should
alwasy always pay off the highest interest debt first, here’s another side of the coin and an argument that it can be good to pay off your lowest debts first.
Personally I side with paying off the higher interest debts first, much in the same way I believe that you should pay off debt before having an emergency fund. That being said, I do realize there are a wide variety of opinions on this subject (and even numerous exceptions that I can agree to) and people should choose the debt reduction plan that works best for them. In the end, any type of debt reduction plan is better than none at all. Feel free to express your opinions on this subject for either side in the comments.
Paying Off Your Lowest Debt First
You have probably heard the tried and true theory that the quickest way to pay off debt is to pay the highest interest bills first. There does come a time, however, when it is feasible to pay off smaller bills first – particularly certain credit cards with high minimum payments. For example let’s suppose that Johnny has been building credit card debt on four separate accounts and now has the following accounts. Leaving aside the option to transfer funds from his higher interest cards to the lowest, for another article when I can devote more time to that particular topic, let us examine the possibility of reducing Johnny’s debt.
|Account||$ Amount||% interest||min. payment|
Supposing that Johnny has come up with $250 a month to use for debt reduction, it would actually be better for him to pay off credit card C first and then use that extra $20 a month to help pay off card D next. This will have credit cards C and D paid off in 4 months and now he is paying off his highest interest account A with an extra $290 each month. This makes sense only because the C and D accounts have high interest themselves.
If account D was only 10% interest it would not be better to pay it ahead of A or B. The length of time required to pay off the smaller debts is very important as well. If account D had more than just a few months of reduction payments on it, the money would do more work to tackle the large A account first.
Paying off the higher interest rates is the best way pure and simple because you save interest by paying on $250 less the next month, but if you have a few small debts that can be tackled in a few months, and in particular if they have higher minimum payments, paying them off first is a great alternative.
The reason that this can be good is that it gives a sense of accomplishment. We are an instant gratification society, and even though he will save over $1000 in interest by paying off account A first, Johnny does not feel that he is accomplishing anything until he is writing one less check per month. Paying off account C so soon makes Johnny feel good that he is getting his debt under control (and thus will continue to pay down debt and not give up on the strategy). Then when he is working with that extra $20 to use on the accounts with larger dollar values attached to them, his confidence is again boosted.
Adding a car loan to this increases the complexity drastically. Auto loans are typically lower interest than credit cards, but have much higher monthly payments. These higher payments mean that paying this loan off sooner could double the amount of monthly funds that Johnny has available to knock out that credit card debt, but paying that money on the much higher interest credit cards instead reduces the interest paid over the length of the credit card repayment schedule and is the best alternative. Unless your car loan has a high interest rate, it is best to pay that extra money on credit card debt than it is to double up that car payment.
As for mortgages, the overall amount of the loan is so large, and the interest rate should be low enough to make this the final step of the debt reduction process, in my opinion. Once the credit card debt is paid off, the money can then be sent to pay off the mortgage quicker.
I read an interesting article about new legislation being proposed in California where your tax refund could be split and sent to two different accounts instead of just one. The reasoning is that by doing this, people will be more likely to send part of their tax refund to a retirement savings account instead of into their personal savings account where it will likely be spent:
Assembly Bill 2439 would allow California tax filers to split their state income tax refund into “money to save” and “money to spend.” Right now, taxpayers can only direct their refund to one account. By allowing us to split our refunds between two accounts, we could send $500 to an IRA and get the rest back in cash. This would promote saving before the temptation to spend sets in.
They give the following study example of why this will work:
Can we expect much from such a small change? Yes. A test of this simple concept in Tulsa, Okla., showed it can work. Community tax preparation programs offered a “refund splitting” option to 500 low-income tax filers. About one-third wanted to participate and people deposited $649 on average — 47 percent of their refunds — in savings accounts. Most importantly, three out of four of these filers had no prior savings.
I guess 33% participation is better than none, but I’m not sure giving people a choice is going to address the real issue. Lots of people have the choice to participate in their company’s 401k plan with matching funds which is an absolute no brainer, yet many still don’t.
While I agree that a choice versus no choice could be better, I also see the potential of abuse for the people it’s supposed to help the most. If these people don’t have savings accounts, are the tax preparers going to give the taxpayers good advice as to where to put those savings? My guess is they will suggest investments where they get a nice, fat commission rather than something that would benefit the person receiving the tax refund. Would you expect more from companies that promote rapid refunds to their customers?
If you are a current personal finance blogger, I have some news that may be quite interesting to you. I am leaving my paid personal finance blogging position at the end of this month and they are looking for someone to replace me. I’m leaving because of time – with all the other projects I have going I just don’t have an hour or so a day to do the job correctly. I actually enjoyed it quite a bit and if time currently wasn’t an issue, I certainly wouldn’t be leaving. It would be a wonderful and fun opportunity for the correct person (it has been for me) and you’ll learn a lot from the editor that you’ll be working for/with.
The writer/editor position is paid, though a part- time income (unless you are one of the current top pfbloggers, it’s likely more than you’re earning now for a lot less work). You need to make one post a day Monday through Friday. The site is one of the most popular and respected personal finance blogs on the Internet – far bigger and more popular than mine here – so you’ll get a lot of recognition.
In order to be successful, you need to be fairly current on what other personal finance bloggers are writing as well as personal finance articles in general from around the Internet. If you spend time daily reading this type of material, then you should have no problem coming up with posts for the position.
If you’re interested in this position, please write to email@example.com and be sure to include a link to your blog so he can see your writing style. I highly encourage all who enjoy pfblogging to apply.
An article titled Men Don’t Buy Tampons which relates how her husband ended up spending about a hundred dollars for a $3 box of tampons (a very funny read that I can relate to having endured the stares when asked to do so in Japan) lead Baselle over at Baselle’s Financial Diary to come up with the 4 E’s of overspending:
Emergency: so important that most of us have a fund named for it. Some emergencies are real (life and limb) and can’t be helped, but there are many emergencies that are fake. Save your money for the real ones. Embarrassment: It keeps grown men from buying just a box of tampons, grown women from negotiating properly for a car or even for a raise, and it keeps all of us from thinking – why should I spend money on this? – or from asking questions – or from thinking – no, I will not buy this – or from thinking – everybody has more money than me, why bother! Emotion: If you’re happy, you want to spend money to celebrate; if you’re sad, you want to spend money to console yourself; if you are stressed, you want to spend money to get out of the situation. Turns out that functional psychopaths make the best financial decisions. The amazing fact for most of us is that we can save the money that we do, despite our emotions. Easy: easy monthly payments on a house or a car or a credit card which will keep you from seeing the total of what you are spending; easy to buy rather than insult the sales person (or embarrass yourself); easy to burn gas waiting for an upfront parking space.
When it comes to debt reduction, these are the four demons that you need to battle to keep your budget in line and doing so is not necessarily easy. It only takes one of these areas, to balloon a budget and find that your debt reduction plans have been completely foiled.
One of the best ways to begin a debt reduction plan is to understand which of these budget busters are the ones that have been keeping you in debt in the first place. Take a look at the way you spend money and figure out which of the four categories best describes the way you spend. Once you have determined what has been putting you in debt in the first place, you will be on much firmer ground when tackling your debts.
Once you know, you can take firm steps to keep the area(s) where you overspend under control. If you know that you are an “Emotional” shopper, you can decide that shopping is not do be done after a stressful day. If “Easy” is your demon, you can determine to figure out the total cost of everything before making a purchase. By knowing what it is that has put you in debt in the past, you can take the steps needed to prevent this from happening again and ensure that your debt reduction plans don’t get foiled by old habits.
You probably are aware that the advertising we see on TV is trying to influence you into buying a certain product. What you might not be so aware of, however, is that the advertising is also trying to influence the amount of the product you use.
The classic example on how what we see on TV can influence the amount we use is the old Alka-Seltzer commercials. Originally, you placed a single tablet into the water and it worked just fine. Then they came up with a “plop, plop, fizz, fizz” campaign where two tablets were used and their sales doubled as everyone thought this was the correct amount to use.
Think about the toothpaste commercials you see. They don’t place a dab on the toothbrush – the amount you need – but a full, length long, rounded amount often with an extra twist. The reason that advertisers want you to use more than you really need is because the more you use, the more of their product you need to buy.
What you need to do is to start to adjust away from what we see in advertisements to using the amounts that you really need to get the job done. Most of the time all that’s needed is half or less of what the advertisements make you believe you need in the ads.
The best way to test what amount you need for everything is to try 50% of what you currently use. If it works, you can try and reduce it even more. If it doesn’t, add a little more and keep adjusting until you come to the perfect amount. Here is a short list of products that you should consider adjusting the amount you currently use:
These are just a few of the items you may use that can be reduced without diminishing their effectiveness. You can try this with virtually every product that you use. By simply moving from what advertisers want you to use to what you actually need, you can save hundreds of dollars a year. Think of it this way. If you succeed, then you’ll only need to buy half as much as you’re currently purchasing.
I put together an article called The Cost Of Bad Credit – More Than Credit Cards Rates because it seems when people talk about bad credit scores, it’s mostly about credit card rates. While these certainly cost people with poor credit quite a bit of money with higher interest rates and extra fees that credit card companies charge to those with poor credit, having a bad credit score will hurt you in a lot of other areas as well. These include getting other types of loans such as mortgages and car loans and will also cost you more with insurance rates. I put together a bit of an estimate of what the poor credit may cost, but I really need to go through and make some estimates to give a better overall idea.
I also know that I’m missing quite a few areas where those with poor credit scores get dinged and have to pay more (if you know some areas I missed, feel free to leave a comment) – would like to expand those too and try and put a dollar value to them too. It’s a good start and foundation on information, but I’d like to dig deeper and make it a quality resource page.