The Wrong Way to Pay Off Debt
Can there really be a wrong way to pay off debt?
Say you have an extra $1000 a month to put toward debt. How can you effectively allocate it to get the biggest bang for your buck?
Turns out, there is a wrong way to do it.
Debt Repayment Strategies
Let us consider the hypothetical example of Dr. Golden Handcuffs (now referred to as Dr. GH).
He earns $260k a year. He has decided he is ready to get rid of all the fixed monthly debt payments in his life and to become debt-free.
He currently has an extra $1000/month to allocate to debt payoff.
He decides to first list out his debts, so he can decide where to start. Here is his debt situation.
If he only made minimum payments on all his debt and did not pay it down faster, he would remain in debt for 30 years and he would pay $357,762 in interest alone.
He smartly decides he doesn’t want to do that.
Let’s get into the different strategies he could use to pay off this debt faster
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The Debt Flood
The debt flood is the strategy I used to think people used to pay down debt, before I started to learn about finances.
It involves splitting the extra $1000 between all the debts and paying a little extra towards all of them.
Dr. GH, for example, has 5 debts. So he would split the extra $1000/mo and put an extra $200 towards all of them every month.
With this strategy, he would pay off his debt in 281 months (23 years) and he would pay $89,524 less in interest over the lifetime of his loans.
Ok, not bad. But, 23 years is a long time to be disciplined and put extra cash towards debt and not a fancy vacation…
Edited to add 12/3/2020: This is assuming a static extra $200 toward each loan for the life of the loan, which I think is typical behavior of most with the set it and forget it mentality.
The Debt Snowball
Another strategy he could use would be the debt snowball.
In this strategy, he would continue to make minimum payments on all his debts and he would put the extra $1000/mo he has in his cash flow towards the smallest loan first, disregarding interest rates.
So, Dr. GH would start off with Car Loan 1 at $10,000. When that one is paid off in full, he would take the extra $1000 + $189 and put it towards the next smallest loan, Car Loan 2. Then he would tackle the credit card debt.
He would continue to do this until all his loans are paid off.
His extra debt payment would get larger and larger as his smaller loans got paid off so by the time he got to his student loans, he would be paying $1000+ $2000+ $189+ $280= $3469 extra towards his student loans, on top of his usual $2839 minimum payment (that’s $6308/month total!)
Here's a recap of Dr. GH's debt situation.
Using the debt snowball strategy, Dr. DH would knock out his first car loan (in blue below) in a few months, the next one (in green) in another year, then the credit card debt (in yellow) in a few months, and then his student loans over the next 2-3 years (in orange).
Debt Snowbal Payoff Order: Car Loan 1, Car loan 2, Credit Card Debt, Student Loans, Mortgage.
If Dr. GH stared his debt snowball in Dec 2020, could be totally debt free in 9 years! He would also save $209,667 in interest paid.
The Debt Avalanche
For some people, paying the credit card loans off third would be a real problem. After all, 19% is a really high interest rate! For them, the debt avalanche would make more sense.
In the debt avalanche, Dr. GH would go after the highest interest rate loan first. He would put his extra $1000 towards his $50,000 credit card debt at 19% first, then go after the students loans at 6.5%.
A recap of Dr. GH's situation
As you can see below, the credit card debt (in blue) would be paid off in a little under 2 years. Then, the student loans (in green) would get paid off over the next 3 or so years. The car debt would not get any extra payments and would get paid off on their usual schedule over 5 years. Finally, the mortgage would get paid off over the next 3 years.
Debt Avalanche Payoff Order: Credit Card, Student Loans, (Car payments at usual rate), Mortgage
Unlike the snowball when Dr. GH got to celebrate a car being paid off in under a year, the avalanche wouldn’t provide him a win to celebrate for almost 2 whole years of being disciplined.
But, with the Debt Avalanche, Dr. GH would be debt-free one month sooner than the avalanche (July, instead of August 2029) and he would save about $6k more in interest than if he did the snowball method.
Debt Avalanche: Debt free in less than 9 years!
Let's Compare the Debt Payoff Strategies
In terms of time to debt free:
Time to Debt Free: 281 months with the Debt Flood, 104 months with the Debt Snowball, 103 months with the Debt Avalanche
And here are how things look in comparison in terms of interest saved:
Interest paid: Debt Flood= $268,238, Debt Snowball= $148,095, Debt Avalanche= $142,926
So, when asked what is the most effective strategy for debt payoff, you can see there is a clear wrong answer here: the debt flood.
The debt flood (paying a little extra on all debts simultaneously) is the least efficient way to pay off the debt in terms of interest saved and time saved. The snowball and the avalanche are clearly superior. Throwing all extra money at one debt at a time, while making minimum payments on all other debts, works better than trying to knock them all out at once. This has to do, I think, with the way loans are amoritized. Early in the loan, much more of the payment goes towards interest.
What about the Debt Snowball vs. Avalanche?
I see choosing between the snowball and the avalanche as much more of a personal choice based on personality and motivation.
The snowball gives Dr. GH early wins within a year to help keep him motivated to keep his snowball rolling. The avalanche doesn’t give a win until almost 2 years in, but does save him a few thousand dollars in the end and makes him debt free a month earlier.
So, for someone who is super motivated and can stay that way for 9 years, the avalanche will work out better. And for all the rest of us who need wins to stay in the game (which is the ultimate goal here), the snowball works out better. With either the debt snowball or the avalanche, Dr. GH gets to be debt free in less than 10 years (much better than the originally scheduled 30 years) and he saves over $200k in interest paid!
Till next week!
Stay frugal, ya’ll!
Standard Disclaimer: Not meant as individualized financial or medical advice. Graphics from unbury.me.
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