paying off debt

If you are trying to get out of debt and you have more than one debt to pay off, is there a strategic “best way” to do so? We will evaluate three recommended strategies to eliminate debt.

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As I suggested in my last post, you need to get your income and expenses in line so that income is greater than expenses.

If you are wasting your resources on destructive debt, clearly, you need to stop “investing” in the destruction of your own productive capacity!

And, as I also said in my last post, if you have created a habit of spending more than you take in (most of which spending is on consumption—“lifestyle” expenses), then it is likely you should “discipline yourself to say no, to do without, to buy only what you really and truly need . . . until your expenditures are lower than your income.”

These fundamental shifts in your spending habits should help you greatly.

But if you are faced with debts—or ongoing liabilities—because of your past spending habits, that means you have some leaks to mend. The interest on those liabilities will weigh you down, consume your substance, and keep you from prosperity.

I have read numerous sources that say the average American spends over 30% of his or her income on interest alone! Look at how much of your mortgage is interest. Consider the proportion of any auto loans you have that is consumed by interest. If you hold a balance on one or more credit cards, consider how much of your monthly bill simply goes toward interest!

So how do you stop the leaks? You pay off the consumptive debts. You eliminate the liabilities.

And how do you do that?

Cut Expenses or Increase Income

Most advisors focus on the “cut expenses” side of the equation. And it is good advice. Indeed, for most of us, it is great advice. We need to make sure we are not part of the 90% of Americans who buy things we can’t afford.

But what about those of us who really can’t cut our expenses any further without causing significant damage . . . or without limiting our own—or our family members’—personal opportunities?

We need “something else.”

And so, for most of us, I would encourage not only unnecessary expense reduction, but smart pursuit of ways to increase our income.

Ask yourself: What can you do to increase your value to others?

  • Study to improve yourself . . . rather than “relax” by the TV? Learn new skills? Gain new abilities? Acquire new licenses or certifications?
  • Figure out how to spend quality time with people who know more than you . . . who are more skilled than you, more successful than you?
  • Create resources—books, videos, blog posts, podcasts, ____—things that will cost you time and effort to create, but cost almost nothing to make available to potential customers?
  • Offer services to neighbors or co-workers?
  • . . .

The reduced expenses (negative cash flow) and increased income (positive cash flow) should provide you means to eliminate your on-going consumptive liabilities.

HOWEVER,

Which liabilities should you eliminate first?

I am aware of various “methods” recommended by various “experts” for reducing one’s interest load.

Pay Off High Interest Loans

When I was growing up, my dad, a math and engineering kind of guy, always pointed out that it made most sense to pay off the loan with the highest interest rate first. Then the next highest interest rate . . . and so on . . . until you have paid everything off.

And from a mathematical perspective, that certainly made sense to me. If you have credit card debt of $13,000 on which you are paying 24% interest (for a total minimum monthly payment of $390), why would you ever choose first to pay off your 30-year $250,000 mortgage that is costing you 4% (that is costing you $1,193.54 in monthly payments)? Yes, you are paying more per month to carry that mortgage (indeed, just over three times as much), but that $1,193.54 is giving you control over more than nineteen times as much money ($250,000/$13,000=19.23)!

So if you want to pay off your debts, get rid of the inefficient credit card debt. Pay it down as quickly as you can. (I’ll have more to say in a future post about mortgage debt.)

That 4% loan is costing you very little, relatively speaking, whereas that 24% loan is costing you tons!

Pay Off Low Balance Loans

Dave Ramsey says you should forget the interest rate. Rather, he says, you should line up your interest-bearing loans according to size of balance. Begin with the smallest balance loan and then work your way up toward the largest. He calls this method the “Debt Snowball.” Feel the pleasure of eliminating your small debts. It will give you emotional momentum to tackle the bigger ones.

As he puts it, “[I am] more concerned with modifying behavior than correct mathematics. . . . [S]ometimes motivation is more important than math. . . . The reason we list smallest to largest is to have some quick wins. . . . When you start the Debt Snowball and in the first few days pay off a couple of little debts, trust me, it lights your fire. . . . [Y]ou need quick wins to get fired up. And getting fired up is super-important.” [Dave Ramsey, The Total Money Makeover. (2007; pp. 111-112)]

Ummmm. Maybe. If, indeed, that’s what “lights your fire,” then go for it. Me? I prefer my dad’s method.

Ah! But there is one more method I heard about recently:

Pay Off “Inefficient” Loans

[Quick summary of my view: forget it. My dad was right. Pay off your high-interest loans first.

But if you want the details of this third (failed) method, feel free to read on! If nothing else, it should convince you ever more deeply of the truth that you want to pay off high-interest loans first.]

I came across an article by Garrett Gunderson in The Huffington Post. (Yes, the same Gunderson I have quoted with approval elsewhere and someone whose views I generally hold in very high regard. I’m afraid he missed it on this one, however.) At first I was intrigued, thinking he might have some new insight. Especially since he attributes this method to a “rocket scientist” named Dale Clarke.

After I did the math, however, I was convinced he is wrong.

Clarke and Gunderson advocate what they call the “Cash Flow Index.” And, as the method’s name implies, Gunderson urges you to pay off the loan that, when you pay it off, will make the greatest positive impact on your cash flow. In essence: all else being equal, ask which loan requires you to pay more dollars each month per loan balance remaining. Pay that one off first.  (Of course, we’re assuming there are no prepayment penalties associated with any loans you are intending to pay off quickly.)

To figure out which loan is least efficient from a cash flow perspective, Gunderson suggests we divide each loan’s current balance by its minimum monthly payment. That, he says, is your Cash Flow Index (CFI). And whatever loan has the lowest CFI is the one you should pay off first.

Gunderson suggests an example: “you have student loan debt at 8 percent interest with a minimum payment of $50, and a car loan at 2.9 percent with a $400 payment.”

Sadly, he doesn’t tell us what the loan balance is in each case. And he doesn’t mention the CFI. But he suggests we might want to pay down the car loan first because “paying off the car loan and freeing up an extra $400 per month in cash flow will give you more immediate flexibility and opportunity in the future.”

Sounds promising. But my innate math sense tells me to work it out in detail.

The problem, from my perspective: Paying off a loan early doesn’t increase positive cash flow except to the extent that it reduces negative cash flow. And whether I pay off principal quickly or slowly, that portion of each month’s payment that goes toward principal doesn’t actually alter the amount of principal I will have to pay.

I have to pay the same amount of principal no matter what.

The only thing I get to choose is how much interest I’m going to pay. And I control that by the rate at which I pay down the debt (the principal).

So let’s do some math.

Math Time!

Setting Up the Problem

I went to DinkyTown.com and used its Enhanced Loan Calculator, calculating for “Loan Amount,” to figure out what size of loans would produce the kinds of payments Gunderson suggested.

You’d need a car loan of $22,316 at 2.9% for 60 months (five years) to produce a $400 per month loan payment. And you’d need a student loan of $5,977 at 8% for 20 years (or $4,121 for 10 years) to produce a $50 per month student loan payment. [I’ll use the $5,977 loan for illustrative purposes, here.]

Question we need to answer: What kind of “damage” am I suffering in terms of interest expenses if I continue to pay both loans at their current (minimal) pace?

When I click on “View Report” in the DinkyTown calculator, I discover that the car loan costs me $53.93 in interest in Month 1 of the 60-month loan. By Month 12, at the end of the year, having paid the loan down at the agreed rate of $400 per month, my interest expense is down to $44.62. Total interest expense for Year 1: $591.52.

And the student loan? Month 1 (when it’s a brand-new loan): $39.85 in interest. Month 12, again, paying down the loan at the agreed rate of $50 per month, my interest is $39.08. Total interest expense for the first 12 months of my student loan: $473.58.

Whew! The car loan definitely costs me more in interest in Year 1.

But push both loans out one more year. The car loan costs me $467.83 in interest in Year 2. And the student loan? $463.10. –Just $4.73 less than what the car loan cost me!

Yet at the beginning of Year 2, I owed $5,851 on my student loan, and $18,108 on my car.

By the beginning of Year 3, I owe $5,714 on my student loan, while my car loan balance is down to $13,775. Expected interest payments for that year: $452 on the student loan; $341 on the car.

And Gunderson wants me to pay the car loan down faster?

Yes! Because the CFI on my student loan at the beginning of Year 3 is 111 which, according to his article, is an “efficient” loan, a “Safe” loan. Meanwhile, CFI on my car loan at the beginning of Year 3 is 23, a loan, he says, that is in the “Danger Zone”!

Really?!?

I think I would prefer to pay off—and would be far more capable of paying off—the $5,714 in my student loan than I would to speed the pay off of my nearly $14,000 loan on the car. Especially since, it appears, by paying off the student loan, I would reduce my interest expenses dramatically—far more than I would if I cut out the relatively small (and rapidly shrinking) amounts of interest on the auto loan.

But maybe I’m overlooking something.

So let’s run some real numbers and see what happens.

Real Numbers

Let’s assume I’m five years past graduation, so I have 15 years of student debt remaining if I continue to pay my $50 a month. And let’s assume I bought my car a year ago, so I have 48 months left on that loan, if I continue to pay at $400 a month.

And I just got a $200-a-month pay raise. I’m thinking maybe I should use some of that “extra” money to pay down my debts.

So let me run the numbers six ways.

  • Pay off both loans at their current pace. Use the $200 for something else.
  • Pay off both loans at their current piece, but, when one of them is paid off, use the extra dollars now freed up from that loan to pay off the second, remaining loan rather than to purchase something else.
  • Pay off the car loan faster than required by using $50 of the $200. And then, when I’ve paid off the car, take all the money that I had been using to pay it off and apply it—along with the ongoing minimal payments I had been paying—to the student loan.
  • Same as 2, except pay off the student loan first, then use all the funds to finish paying the car loan.
  • Do the same as I’ve just proposed, except take all $200 of my raise and apply it to the car loan, then, once that has been paid off, apply everything I had been directing toward the car and maximize payments on the student loan.

And,

  • Do the same as I’ve just proposed, except pay off the student loan first, and then the car.

Let’s see what happens.

Scenario 1: Pay off both loans at their current rate.

At the point we begin our experiment, we are 60 months into the student loan; we have 180 months remaining to pay it off. And we are 12 months into the car loan; we have 48 months remaining to pay it off. Total interest I will have to pay on the car for the 48 months of the loan remaining: $1,092. And the interest on my student loan for those 48 months? $1,548.

(!!! Those two interest payment numbers ought to warn us that something funny is going on! If the student loan is so “efficient” and “safe,” why have I paid over 41.8% more for it than I did for my car?)

Despite the warning bells that ought to be going off in my head, I trust Gunderson and Clarke and their CFI.

So now, having paid off my car loan, I realize I have $400 “extra” that I can either use to buy something else (perhaps another car?) or invest somewhere . . . or pay off my student loan. This being Scenario 1, and, 48 months from now, my student loan still bearing only a weak “Caution” sign (with a CFI of 87.6), I am going to spend or invest the money elsewhere and let the student loan run for its full 240 months (or, at that point, 132 months remaining).

By paying my student loan at the same rate for the maximum period of time, I will pay $2,218 in additional interest (from Month 61 through 240). In other words, my total interest on the loan will be $3,766. On the student loan alone. Both loans together (car and student loan . . . and ignoring any additional loan I might contract with the “extra” $400 “capacity” I have freed up): $4,858.

Keep that number in mind. $4,858. That will be our benchmark.

How much better (or worse) off will we be if we follow another scenario?

Scenario 2: Pay off both loans at their current rate until I have paid one off; then use those “extra” funds to pay off the second loan.

This is the same as Scenario 1, except that, 48 months from now, I will have paid off the car loan. Only this time I will use the “extra” $400 to pay off my student loan.

What happens?

Amazingly (or perhaps not): by paying $450 a month toward my student loan (the $50 I was originally paying, plus the $400 no longer going to the car loan), I will pay off the student loan within 10 months from the time I begin making those additional payments—not 180 months from now, but 58 months from now: 132 months faster.

Total interest on the student loan during those 10 months I am paying it off super fast?  $114.

And the sum total of interest on car and student loan over the course of the 58 months from now until I have paid both loans off: $2,803—$2,055 savings . . . on interest.

Talk about a “discount”! My interest costs went down by a whopping 42.3%!

Scenarios 3 and 4: Raise the payment rate by $50 per month.

Gunderson suggests we should pay off the car loan first. Its CFI is way lower than the student loan. Indeed, he says, it is almost “dangerous” not to pay it off.

So let’s pay pay off the car loan first.

Paying Off the Car Loan First

Instead of paying only $400 a month toward the car; I’m going to pay it off at the rate of $450 a month . . . while I continue to pay my student loan at its regular $50 a month rate.

Instead of 48 more months of car payments, by bumping the $400 by just $50 a month, I bring my payoff date on the car six months closer: I will be paid off in less than 43 months. And instead of paying $1,092 in interest, I will pay $965, an 11.7% savings of interest cost.

Better yet, if I now apply the $450 I was spending on car payments to now pay off my student loan, I will bring my student loan payoff date forward by 128 months. Instead of paying $50 a month for an additional 160 months, I will be done with the student loan payments 52 months from now! And my total interest cost for car and student loan drops from $4,858 to $2,505—a savings of $2,353 or 51.6% of interest costs over Scenario 1!

Paying Off the Student Loan First

Despite Gunderson’s recommendation, I want to check how things look if I apply the $50 to my student loan instead.

It turns out my student loan payoff date is brought forward 115 months; I’ll be paid off by 65 months from now. That’s long after my car will have been paid off through regular $400-a-month payments, so I won’t be able to speed up payoff of the car. Yet the total interest I will spend on my student loan during the 65 months I’ll be paying comes to only $1,223—a full $317, or 25.9%—less than the $1,540 of interest I would have to spend on the student loan if I used the $50 a month to pay off my car!

Now. Total my interest expenses for both car and student loan and I’m looking at $2,315—a savings of $2,543 or 52.3% off of Scenario 1, and an 8.07% improvement in efficiency over paying off the car first! ($2,543 of savings / $2,353 of savings = 1.0807; i.e., paying off the student loan first saves me 8.07% more than does paying off the car first.)

Scenarios 5 and 6: Raise the payment rate by $200 per month.

Things get even more interesting here.

Paying Off the Car Loan First

If I take my entire $200 raise and apply it to car payments, I’ll be paying the car loan at $600 a month. That will take me out from under the car loan in less than 32 months from now. Total interest on the car will drop to $717—a savings of $375 in interest over the original scenario, or a 34.3% reduction in interest.

And if I turn the $600 a month I was spending on the car and now apply it to my student loan, I’ll have the student loan paid off 142 months early—38 months from now! Total interest on the student loan from the start of our experiment to full payoff: $1,145. And all in, interest on car and student loan together? $1,862.

Can paying the student loan down first possibly beat that?

Paying Off the Student Loan First

By paying the student loan at $250 a month, I shorten payoff time by 157 months. I should be out from under my student debt 23 months from now. And total interest on the loan will drop from $3,766 to $422, a fantastic reduction of $3,344, or an 88.8% “discount.”

And if I now turn those “extra” $250 toward paying off the car loan (which hasn’t quite been paid off): I shorten the car loan period by 10 months, and my total interest cost for the car drops from $1,092 to $972—a savings of $120, or 11%. And under this scenario, total interest cost for both car and student loan is $1,394—a full $468 or 25.1% less than I would spend on interest if I used my $200 to pay off the car first, and $3,464—or 71.3%—less than what I would spend if I simply continued to pay both loans at the current pace.

Summary

Both Loans are Paid Off

Total Interest Cost Savings
$$

%

Pay at Current Rate

180 months from now

$4,858

Pay at Current Rate and, When I’ve Paid Off One Loan, Apply the “Extra” to the Second Loan

58 months from now

$2,803 $2,055

42.3%

Pay $50 more to Car, then to Student Loan

52 months from now

$2,505 $2,353

48.4%

Pay $50 more to Student Loan, then to Car

65 months from now

$2,315 $2,543

52.3%

Pay $200 more to Car, then to Student Loan

38 months from now

$1,862 $2,996

61.7%

Pay $200 more to Student Loan, then to Car

38 months from now

$1,394 $3,464

71.3%

Key Takeaways:

  • Never contract destructive debt.
  • Avoid consumptive debt to the extent possible.
  • If you contract consumptive debt, seek to rebalance your cash flow so that you have more positive than negative cash flow. Do that by reducing expenses, as reasonable, but seek to increase income whenever you can.
  • Pay off your highest interest consumptive loan first. Then the next highest interest consumptive loan. And so forth.
  • And, finally, a good word of wisdom from Gunderson’s article. “Sometimes,” he says, “it is sensible to make just the minimum payment to all of your loans and delay paying any of them down.”

    We call it the 90-Day Debt Delay.

    Why do this? Because . . . sometimes it’s a good idea to put your money to a more productive use than paying down a loan. . . .

    For example, you may have a credit card with a 13% interest rate. But your business may also be returning 25 percent for every $1 you put into it.

    Why pay down a 13 percent interest loan when it means missing out on earning 25 percent interest?

    It’s the old observation about productive debt. Who cares if it’s costing you 13% if you are making 25%? . . . Just be sure you’re really investing in something productive . . . that is returning you something more than you are paying for the loan.