Pay Off Your Debt, the Right Way
This is the 2nd article in my series about how Americans are going broke. The first article, Americans Are Going Broke, But Don’t Know It Yet, I wrote about how America is going through strange economic times. I suggested different things you could do that will financially help you. As a recap they are:
- Cut Spending
- Repay your Debt, the right way (this article)
- Increase your productivity
Last time I covered 9 different ways you could cut your spending. In this article I’m going to teach you how to repay your debt, the right way. But first, let’s unpack what’s going on with Americans and their debt.
Americans are in debt up to their eyeballs. According to the Federal Reserve of New York, American households are up to $17.29 trillion (with a “T”) in debt. The majority of it is mortgage debt, however the non-mortgage debts (auto loans, credit cards, etc.) are around $4.80 trillion (1.08 trillion are just credit cards). And because of the increase in interest rates, debt burdens are getting worse.
As Ray Dalio mentions in his famous video “How the Economic Machine Works in 30 Minutes“, one of the dangers of having too much debt is that if your debts rise faster than your income, your debt burdens will eventually crush you.
There are different ways to pay off your debt, the right way (since most people it off the wrong way.) I’m going to show you what they are. First, I’ll go over four debt saving tips and then I’ll cover two debt payment strategies.
Strategies to Pay Off Your Debts, the Right Way
Tip #1 Consolidate Your Debt
Consolidate your debt – if you have multiple lines of debt: credit cards, auto loans, student loans, etc. You should consider getting a single loan with a lower interest rate that would put them all under one umbrella. That way you have only one monthly payment, and the interest rate is lower.
That doesn’t mean after you consolidate your debt to go and put more money on your old credit cards. The idea is to pay down your debt, the right way. Not increase your debt the wrong way.
Tip #2 Always Pay More Than the Minimum
Pay more than the minimum – In case you haven’t read my article on compounding interest, you should go back and read it. Bottom line: you make more money by compounding. You know who else knows that? Banks and Credit Card companies.
That’s why people who pay the minimum on their student loans, wake up 15 years later to see that their student loan balance is more than when they originally took out the loans. You always want to pay more than the minimum to reduce the interest you’re paying others.
The only time, you don’t pay more than the minimum is if you have a fixed payment term (like a mortgage), and the interest rate is so unbelievably low, that the rate of inflation is greater than the interest rate of the debt (e.g. you have a home loan with 2.875% interest rate). Remember, most interest rates for credit card are around 15% or more.
Tip #3 Pay More Than Once a Month
Pay more than once -If you make more than one payment every month, it reduces the amount of interest you will pay the bank. Remember that interest is accrued based on the average daily balance during the month. The lower your balance is on any given day, the less interest you pay the bank.
Tip #4 Shorten the Length of Your Loans
Shorten your loans -The longer your loan is, the more interest you pay. If you can shorten the loan length, you will pay less in interest. That’s why when people buy homes the lender gives you the option of getting a 15-year loan vs. a 30-year loan. Sure, the 30-year loan is cheaper to pay month-to-month, but the interest you pay the bank is way more.
Here’s an example: Assume you have a $300K mortgage with 6.00% interest rate. Here are the differences between 15-year, 20-year, & 30-year mortgages.
|Amount of Interest over length of loan
As you can see, by shortening the length of your loan from 30-years to 15-years, you save over $190K in interest.
Now that’s I’ve gone over a few debt saving tips, now I’m going to tell you about the two most common strategies to pay down your debts, the Snowball Method and Avalanche Method.
Strategy #1 Debt Snowball Payment Method
The Snowball method – is concerned with the amount of debt you have, not the interest you are paying on your debt. This is popularized by finance guru Dave Ramsey, and it tells you to make the minimum payment on all your debts. Then make an extra payment on the smallest one, to get that paid off faster. And after the smallest debt is paid off, take the amount you were paying on all your debts, and move on to the new smallest debt. The #1 benefit from using the snowball method is psychological, since you are paying off smallest debts first, you are seeing progress quickly. The biggest disadvantage is that you are not being the most financially efficient, since you are not paying down the debt with the highest interest rate first.
Strategy #2 Debt Avalanche Payment Method
The Avalanche method – is the opposite of the snowball method, because it prioritizes the interest rate over debt size. Just like the snowball method you make the minimum payment on all your debts, but instead of making extra payments on the smallest debt load, you make the extra payment on the debt with the highest interest rate first. After that’s paid off, then you move on to the debt with the next highest interest rate. The biggest benefit of the avalanche method is that you get all your debts paid off faster and pay less interest, but psychological it’s difficult to keep up with it, since you don’t see any progress for a long time.
Differences of the Two Strategies
|Balances are given priority over interest rates
|Interest Rates are given priority over balances
|Pay down smallest balance first
|Pay down highest interest rate first
|Once smallest debt is paid off, move on to next smallest debt
|Once highest interest rate is paid off, move on the next highest interest rate
|Pro: psychologically easier to implement because you are seeing progress faster, since you see small debts being paid off
|Pro: you pay less interest in the long run, thereby your entire debt load is paid off faster
|Con: you pay more interest in the long run
|Con: you may not see progress for a long time, especially if your highest interest rate debt is also your biggest monetary debt.
|Con: because of the psychological component, most people aren’t able to consistently use the Avalanche method for long periods of time.
Which one would I suggest? Obviously, it’s more financially prudent to use the Avalanche Method, since you paid less interest in the long run. But because the smart phone has made us crave instant gratification, the Snowball Method would be best for most people. That’s because every time a small debt is paid off, you will get a burst of dopamine, reinforcing you’re heading in the right direction.
Now that I’ve helped you learn how to cut expenses and pay down debt, the right way, in my next article in the series I’m going to go over different ways to increase your productivity (i.e. make more money!)