One thing that has brought a lot of dilemma to a person with more than one loan to pay, is which loan to pay off first when you get extra cash. This is where you’ll need the services of a financial expert to get a clear picture of which option is best for you, that is, pay off the debt with the highest interest rate first or the one with the lowest loan amount. Cornie Herring illustrates the above dilemma in her article that clearly explains the decision you may be faced with if you come across some extra cash.
In your efforts to get rid of debt as soon as possible, you pay more toward to your debt when you have extra money. On every extra dollar you make, you will save in total interest and shorten the time you get rid of it significantly. The question is which debt should you pay first with the extra dollars you have?
There is no right or wrong answer; it depends on what you want. Most debt relief guides will go for the approach of paying the highest interest-rate debt first. In fact, this is a better approach because it will save more money and helps you to get rid of it faster. But, psychologically it is a more stressful approach as you will feel that there is no movement in reducing your debt during the process of paying it, because all debts still remain. On the other hand, if you choose to pay off debt with smallest amount first, then psychologically you will feel that you are getting rid of them one by one. So, whether you should pay more toward smallest amount debt or focus on paying the highest interest-rate debt depends on your choice. However, let’s explore each approach by example so that you have better picture on which approach suit you better.
Jack Brandon makes $60,000 annual income yearly ($5,000 monthly), and he has three loans: $6,000 at 3.85%, $12,000 at 8% and $40,000 at 4.50%. He likes to focus on one loan at a time by paying more toward it while paying other with the minimum payment. 30% of his monthly income will be used to pay the loan so that he can get rid of debt faster.
Assumed that the repayment period of each debt was for 10 years, the Jack’s minimum payments are:
a. Minimum payment for $6,000 debt at 3.85% is $60.32
b. Minimum payment for $12,000 debt at 8% is $145.59
c. Minimum payment for $40,000 debt at 4.5% is $414.55
The total monthly minimum payment for Jack is: $60.32 + $145.59 + $480.04 = $620.46
Since Jack plans to use 30% of his income to pay for his debt, he has $1,500 to be used for this purpose.
Let’s explore each approach with the scenario:
1. Pay more toward smallest amount first
Using this payment method, Jack will focus on paying extra dollars to the smallest debt while making only the minimum payments for the rest. After getting rid of $6,000 debt, he works on $12,000 and finally on $40,000 debt. With this approach, Jack takes 7 months to clear $6,000, 19 months to clear $12,000 and 45 months to payoff $40,000.
Jack will take 45 months to clear off the 3 loans, and pay a total of $5456 on interest.
2. Pay more toward highest interest-rate debt first
Using this payment method, Jack will focus on $12,000 loan first because it has the highest interest among three. He makes extra payment to the highest interest-rate loan while making only the minimum payment for the rest. With this approach, Jack takes 13 months to clear $12,000, 40 months to pay off $40,000 and 43 months to clear the $6,000 loan.
In this case, Jack will need to use 43 months to get rid of his debt with a total of $5021 on interest.
In summary, although the second method helps to get rid of debt faster with less interest, the first method that use to pay the smallest debt first is more encouraging as you will see one of the loans, the $6,000 loan is paid off after 7 months, and left with only 2 loans to focus on and after 19 months, you left only one loan to be cleared; comparing the second method which focuses the payment on the highest interest rate debt first, Jack will only see his debt to start get rid of after 13 months and need to wait until the 40th months to totally get rid of second loan. Now you have a better idea on both methods of debt payment, you choose your preferred method to get rid of your debt.