- Posted by NateKragness on October 13, 2009
Almost everybody has at least some debt, and there are many reasons you might find yourself owing money to others. Unfortunately, most financial pundits don't appreciate that there are plenty of valid reasons to go into debt, and not everybody is just living above their means and squandering their income. For example, most people I have worked with have debts related to investments, whether its investing in their own education (student loans), real estate (rental property mortgages), small business loans (or credit card debts related to the business), etc. Medical bills and funeral expenses are also fairly common. But, regardless of how you managed to get yourself into debt, if you want to live a debt-free life, the escape plan is always the same. However, there is a lot of contradictory advice out there regarding the best way to get out of debt, and in this article we will compare and contrast the two prevailing methods.
Before getting into the specifics, there are some action steps you need to take, regardless of which method you decide to employ to escape your debts. First, you need to have a clear understanding of where you stand. Make a list of all your debts; include the name of the creditor, your account number, the current balance, the minimum payment required, and the interest rate on the debt. Once you have aggregated this information into one location, you will have a clear view of where you stand, and where you need to go. Next, decide which debts, if any, you don't need to pay off. Sometimes, carrying a debt is a good thing. For example, if you own a rental property that has positive cashflow, there's not really a pressing need to get rid of that mortgage debt. If your renter is paying the mortgage interest, that investment is making money, in spite of the debt. There's no pressing need to pay that off, and it shouldn't be a high priority. Additionally, if you have very low-interest loans, you might not want to pay those off either (Does Paying Extra on your Mortgage Make Sense?). Keep in mind that debt is not inherently bad, and you shouldn't indiscriminately try to eliminate all debt from your life (at least initially). Part of making prudent financial decisions is recognizing and differentiating good debts from bad.
Now that you have your aggregated list of debts in hand, we can consider the two prevailing methods of debt reduction. The first, popularized by Dave Ramsey, is called the "debt snowball" method, and it focuses on paying down your lowest balance first, regardless of the interest rate. So, if you have a $500 credit card balance and a $4,000 student loan, you would focus on the credit card first, and once it is paid off, move on to the student loan. Employing this methodology, you will see your smallest debts being eliminated first, and the theory is that this will provide emotional motivation for you to continue eliminating the rest of your debts. I call it the instant-gratification method, as you see tangible results quicker, but it ultimately takes longer to get out of debt. And how gratifying is it, ultimately, to pay more interest than you need to?
If you're serious about getting out of debt, it only makes sense to do it in the most prudent manner possible, and this brings us to the second method, which is to focus on the debts with the highest interest rate first, regardless of the balance on the account. This means you will ultimately pay less interest over time, and you also pay off all your debts faster. It's true that, using this method, you don't have the gratification of seeing your individual accounts being paid off, but you DO see your total debt decreasing even faster than with the "debt snowball" plan. To keep yourself encouraged, and provide a similar level of emotional gratification to the Dave Ramsey strategy, make a chart or spreadsheet that tracks ALL your debts, and see how quickly you're eliminating them as a whole, as you focus on the highest interest rates first. Eliminating low-interest debts while you are being destroyed by high-interest balances is financially irresponsible, and using the excuse that its "emotionally motivating" to be imprudent is just a cop-out. You need to eliminate your debt as quickly as possible, and you do this by paying down the highest interest rates first. It's simple mathematics, and that should be all the motivation you need.
To better understand these two plans for debt-reduction, consider the following (intentionally exaggerated and extreme, but still valid) hypothetical example: suppose you have a $10,000 student loan at 4% interest (minimum payment $200), and a $20,000 credit card balance at 29% interest ($500 minimum payment). Now, suppose you have an extra $300 per month to apply towards debt reduction. According to Dave Ramsey, you should focus all your efforts on the student loan, while making minimum payments on the credit card. With the extra $300 per month towards the student loan, it would take about 17 months to completely eliminate that debt, leaving you with just the high interest credit card. You would now re-direct the funds you were paying towards the student loan into the credit card, meaning you would be paying $1,000 per month on it. It would take another 30 months to eliminate the credit card, and so the total time using the "debt snowball" plan would be approximately 3 years and 11 months. You would have paid about $16,000 in interest using this method.
Now, consider the scenario if you instead focus on eliminating the high-interest credit card first. Since you would be paying $800 per month towards it, it would take about 33 months to eliminate the credit card debt. Re-directing those funds into the student loan would eliminate that balance in another 6 months, meaning you would be debt-free in about 3 years and 5 months. You would have paid about $10,000 in interest.
As we can see, using the instant-gratification "debt snowball" method costs more than $6,000 in extra interest payments in our example. Clearly, paying down the debt with the highest interest rate makes the most prudent financial sense. And for me, personally, I find a whole lot more gratification in saving $6,000 than in seeing one of my debt balances reduced to zero. When you think about it, does a completely arbitrary number (the number of accounts you own with a balance) really matter? If you owe $30,000 on one credit card, how is that any different than owing $30,000 split between ten cards? The number of accounts you have is completely meaningless, and for that reason the "debt snowball" plan really doesn't make sense. If paying your low-balance debts gives you emotional gratification and encouragement, and helps you to eliminate your debts, great. I suppose its better to get out of debt than to not, even if you do choose to pay a lot of extra interest in the process. But, I really don't see how you would be emotionally pleased to realize you're paying an extra $6,000 for absolutely no reason. Make a commitment to eliminate your debts, focus on the highest interest rate, and track your progress. You'll save a ton more money than the "debt snowball" plan, and that fact alone should be all the motivation you need to get yourself out of debt.
- Posted by NateKragness on September 25, 2009
Many households send in additional payments on their mortgage from time to time, but does this make prudent financial sense? When you pay down your mortgage balance, you decrease the future interest you will pay on your loan by a certain amount. But, you also lose the ability to invest the money you send in on other investments. In other words, if you send $500 to your mortgage company every month, that's $500 you can't be investing elsewhere. So, the opportunity cost of making extra payments towards your mortgage is that you can't invest that money somewhere else. Thus, it only makes sense to pay down your mortgage balance if you can't get a better return elsewhere.
For example, suppose you have a 30-year interest-only mortgage of $300,000 at 6.0% -- this means you would be paying $1,500 per month in interest on the loan. Now, suppose you receive an unexpected windfall of $10,000 and are faced with the decision of what to do wiith it. If you pay it towards your mortgage, you will reduce your balance by $10,000, which at 6% interest would save you $18,000 over the course of the loan. At first glance, it doesn't seem like a bad idea -- after all, it's probably more than a bank will pay you to keep your money in a savings account. But, since you are most likely getting a tax deduction on your mortgage interest, this means that you are essentially increasing your tax liability by paying down your mortgage interest. When taxes are working against your investment, it slows down your asset growth. Because of these tax ramifications, if you're in the 25% tax bracket, you would only be earning 4.5% interest by paying down your 6% loan; it turns out that $10,000 investment would only save $13,500 over the course of the loan. That's not a great return, and it's an illiquid investment as well -- while you will save money on your mortgage payment every month, you won't be able to get that $10,000 back. If I'm giving up money that I can't touch for thirty years, I want a better return than 4.5%. The opportunity cost is too great to invest in paying down my mortgage.
So, where can we re-direct that money to get a better return? Consider that the historical rate of the S&P 500, which roughly approximates the general returns of the stock market, hovers at just above 9% annually. If you invest that same $10,000 into the stock market, and earned average returns over 30 years, your investment would be worth about $27,000. Regardless of your tax bracket, that's still a lot more money than you would get by making an extra mortgage payment. And, you gain the benefit of liquidity: you have the option to sell off some or all of your assets at any. So, unless you have a very high interest rate on your mortgage, it's generally better to invest your money somewhere that has the potential for higher returns. If you make a 4.5% investment when you could be earning 9%, the opportunity cost of the equation implies that you're actually losing money by picking the relatively lower return.
Of course, there are situations when paying down the mortgage makes emotional sense, and that can be reason enough to abandon financial prudence. Having a general peace of mind about your financial situation is far more important than maximizing every possibly investment decision that you make, and if making extra principle payments improves your sanity, by all means, aggressively pay down your mortgage debt. There is no quantifiable price tag you can place on having peace of mind. For me, this comes from knowing that I'm making the most prudent decisions about my financial future, so I personally avoid paying down my low-interest mortgages, and instead let my money work in more aggressive investment vehicles. As much as I hate debt, mortgage or otherwise, if the opportunity cost of paying down those debts is simply too high, it behooves me to invest my money elsewhere, at higher returns, while continuing to make the minimum payments on my low-interest money.