I recently “met” this interesting fellow, just entering what used to be called middle age. He writes about some interesting stuff. Last week (as of this writing; so by the time this is published, it’s probably last month), he wrote about turning his fiscal life around.
He has a plan to getting himself out of $ 390K worth of debts. It was a good plan, but there was a big hole in it. I understood why he made that choice- but I vehemently opposed it.
What did he suggest? He suggested that one should:
- Prioritize the list by the amount owed (smallest debt first)
- Pay all the minimum payments, and,
- Put the extra cash toward the smallest debt (in this case, it would be $ 300 a month)
I hate to burst anyone’s bubble (OK, hate is a strong verb), but this is NOT a good plan. As I told him, I understand the concept of eradicating a debt soonest, to bolster one’s belief that progress is being made… but, this system usually means one (a) spends way more money than needed and (b) may actually cost us more money than we ever owed. As an example, let’s consider the following debts.
The first problem is that credit cards (and other vendors) have different methods of computing minimum payments. The choices are the percentage method or the percentage+interest+fees method.
The percentage method chooses something between 1% and 3% of our total balance as a minimum payment. A 3% minimum payment assures that we will pay the balance due in 33.3 years- if we don’t use the card further- and have no additional interest charges. So, really that means we will pay down the debt in closer to 40 years.
The percentage-interest-fees method means we will pay that same (range of) total balance due, plus the interest that was charged this month, plus any fees (annual fees, late payments, etc.) In this case, assuming we charge nothing new on the cards, you will pay more than minimum payment above (since we are paying the current monthly interest); the balance gets paid in about 33 years (dependent upon the interest rate charged) under this program- if we only pay the minimum payment.
I am sure you can immediately see the problem with minimum payments. We will never get out of debt if all we pay are the minimum payments.
Yet, Damond had said he was going to pay additional sums of money. That is the true answer. Not only the $ 300 he has budgeted, but he should consider using any income tax refunds he gets to lower his principal debt. Moreover, the best plan is to NOT pay the card with the lowest debt first.
No, the trick is to pay the debt that has the highest interest rate imposed upon us. (This is more important as the interest rate charged increases; many folks who experience cash flow problems have significantly high interest rates imposed on their credit balances.) Yes, it’s true, we won’t see an entire bill disappear quickly. But, think of this trade-off. Would you rather see that $ 1000 bill be paid off in 4 months, or paying off the $ 5000 bill first, which takes 16 months- but that also means you saved at least $ 250 over the 18 months (which is when you’ve also paid the lower debt off- 1 whole month quicker than was possible under than Damond’s plan.)
But, we need the reassurance of which Damond spoke. So, we need to do to post a graph of our debt balance each month. In so doing, we will see – graphically- how our debt is being attenuated.
And, we all will be suitably motivated.
There’s only 11 days left to sign up for Medicare Advantage and/or Medicare Part D. And, 18 days to elect our PPACA (Obamacare) options.
3 January 2018
Today’s Washington Post had an article by Christopher Ingraham that provided the same basic concept. He just didn’t consider the feedback option, to let folks stay motivated to pay down their debt.
https://www.washingtonpost.com/news/wonk/wp/2018/01/02/most-people-are-paying-off-their-credit-card-debt-all-wrong-are-you/?utm_term=.cb76085bed97
Great post. I agree that your method sounds much better than the other guys plan. Interest can be a killer.
Thank you so much for the visit, Mr. Smith!
Getting out of debt means assuring that interest payments are minimized.
I’m the type that doesn’t like to pay interest or CC fees our cards have no annual fees and I pay the balance in full monthly. It works our great because iake money with the cash back from the cards.
Martha, I’m with you on that. My balances are paid in full.
But, I’ve also had times when the desire (paranoia?) isn’t met with a flowing wallet. In those cases, I chose to pay the lowest balances in full first, leaving just one card accumulating debt. But, this also meant three of my (four) cards never imposed a fee (you know, on those “rolling balances” which mean that even though you paid the bill in full by month two or three, you still got hit with interest charges for a few more months).
I’ve read so much “advice” suggesting you pay down the smallest balance first. It never made sense to me and I’m not even that mathematical. I think many people need the visual – it would sure help me. Meantime, hoping that man does succeed in paying off that debt.
Alana recently posted..Charlotte Russe #FlavoursomeTuesdays
I hope so, too. I shared my initial response to his plan- and have clearly shared this longer response with him.
It’s the kind of financial education we should be providing our tykes in school, too!
Thanks for your visit and comment, Alana.
That is very nice these info are very useful also the design of blog is very nice thanks for share you blog with us I love this blog
Thank you very much, Prabjot Singh.
Hopefully, you won’t find yourself falling a little behind.
Roy,
Thank you for shedding light on an alternative solution. I appreciate the dialog as I find these kinds of discussions create an opportunity to grow and learn.
I want to clarify some things, which I’m not sure is captured in your article. If so, please feel free to help me see where I’m missing it.
Let’s say the assumption is that I’m using the extra $300 a month. Based on the plan I’m using, I would apply it to the $1000. According to my thought process, it would only take me 3 months to pay it off, but I assume you’ve added interest, which would then take it to 5 months? Is that accurate?
Using the snowball strategy, I apply the $25 I was using to maintain the monthly installment and add it to my $300, which is $325 each month. Once it’s been paid off, I add that $325 to the $125 on the $5000 debt. At $450 a month, it would only take 11 months to pay it off, assuming I’m attacking the whole $5000. After 3 months of paying minimum payments, I assume it’s less than $5000, which means it would be sooner than 11 months.
Moving on to the largest debt, we now have $800 attacking the largest debt ($300+25+125+350). Assuming we were attacking the original debt, and the monthly payments didn’t reduce the balance, it would take, at worse, 32 months to pay off all the debt. This does not include any tax refunds applied.
Is this what you project in your model? If so, I didn’t see that being reflected.
Looking forward to your response.
Damond Nollan recently posted..Bruised But Not Broken
I did NOT say to choose the highest debt, Damond. I said to pay the debt with the highest interest rate. So, your choice was to pay the lowest debt. Which does mean you would pay that amount off AFTER four months (including the interest)- which means it is paid off by month 5. All of my calculations were based upon you paying the minimum payment (which is what you said you paid), but you allocated an additional $ 300 a month. I made NO changes to the the fact that when a debt is paid off, you might be able to add the minimum payment you no longer had to pay on a debt to another bell. Should that occur, you would pay off all subsequent debts in a shorter time.