This week I’m going to give you a free class in how to get out of debt as fast as possible. To do it, I’m going to show you a simple game. Then I’m going to make it more and more realistic while showing you how to win every time.
So let’s play… The Debt Game
You have two debts. Both debts are for $100.00. It’s the beginning of the month. You are receiving one hundred dollars per month to eliminate your debts. Assume there is no additional penalty for not paying a bill. One debt has a 10% interest rate per month. The other debt has a 25% interest rate per month.
How much should you pay towards each bill to get out of debt and spend the least amount of money? The answer may seem obvious (and it is) but let’s play it out and see what happens…
If you make no payments at all, you would still owe the original $200.00. In addition, you would incur a $10.00 penalty from the loan with 10% interest and a $25.00 penalty from the loan with 25% interest. So at the start of the next month you would have a debt of $235.00. Oops! Wrong way to go!
Next, let’s make payments on each bill. At the end of the month, you will have interest in both bills. Let’s say you put $50.00 towards each bill. So, at the end of the month, you still owe $50.00 on each one. The 25% debt adds another $12.50 to what you owe. The 10% debt adds another $5.00. With this choice at the start of the next month, your original $200.00 debt will drop to $117.50. Better, but not optimal.
You could also pay off one of the debts completely. Let’s pay off the debt with the smaller interest rate. In this case, you would eliminate the 10% penalty completely.
However, you would still owe 25% on the remaining bill. So that’s $25.00. At the end of this scenario, you end up owing $125.00 at the start of the next month. Ouch!
In the last case, you pay off the debt with the highest interest rate. So, the 25% debt is removed. You still owe 10% on the remaining debt or $10.00. So, in the second month with this payment plan, you would owe $110.00.
So, which debt should you pay off first?
In this simple example game, you would pay off the loan with 25% interest first. By doing so you eliminate a $25.00 penalty and keep the $10.00 penalty. Any other combination results in your owing more money.
The important thing to notice is that we owed $200.00 total. In each case (except the first one), we paid $100.00 towards the actual debt owed. The difference in the amount we ended up with was strictly a function of what the interest rate was on each debt. The more you pay towards the higher interest rate item, the less money you will owe going forward.
Now, let’s make our game a bit more complex…
In a real debt, however, the situation seems more complicated. The lender will almost always require that you – the borrower – must pay some interest on the loan for that month plus a percentage of the actual amount you owe. If you understand this then you can see how loans actually work and the fastest way to pay off any loan.
Let’s say that the person making the loan wants it paid off in ten months. If you borrow $100.00 he will want $10.00 of the loan paid to him each month PLUS the interest on the amount you still owe. So, in the example above. The lender who issued a loan for $100.00 at 10% interest would want $10.00 paid off on the loan, plus 10% interest on the $100.00 for another $10.00. That means he wants $20.00 for the first month. The second loan at 25% interest would want $10.00 paid off on the loan plus 25% interest on his $100.00 or $35.00.
The actual amount of the money you borrowed that you still owe and pay interest on is called the principal. So, both lenders want you to pay off $10.00 of principal plus the interest. ($10.00 from one lender and $25.00 from the second.)
So, the rule for getting out of debt is actually very simple. You ALWAYS pay any extra money towards the principal with the highest interest.
This is IMPORTANT. It is easy to see that this is true when the amounts are the same.
However, our reasoning can easily get clouded when the amounts differ.
If we significantly increase the debt amounts to say $5000.00 for both debts you can see that by focusing on the debt with the largest interest rate you would get out of debt much faster. The 25% interest loan is adding an additional $250.00 to your debt while the 10% load is only adding $50.00. Paying off the 25% loan would clearly be the priority.
However, when you shift the debts to an uneven amount we can be easily misled. If we change the number we owe to $5000.00 for the 25% debt and $1000.00 for the 10% debt a strange thing begins to happen. Paying off the smaller debt suddenly seems to be the better choice. Our reasoning shifts. “I can pay off the smaller debt and then use the money from the second debt to pay off on the first debt. I’ll be getting out faster!
This doesn’t work! Why? Because you are paying down the principal on the smaller debt while paying the interest on the larger debt and keeping the principal on the higher debt. Interest rates will increase your debt based on the principal you owe. Even though you eliminate one debt, the amount of interest you will accumulate on the other will ALWAYS exceed what you would have saved if you had paid down the principal on the debt with the greater interest.
So, paying off the smaller debt with the lower interest rate might make you feel good, but it will actually make you spend MORE money. Remember that. Sometimes we really need the win to keep going. In that case, you can choose to pay off the smaller debt to keep going. But recognize it is going to cost you more and can actually take longer. It’s sort of like running a race where you have a backpack with some rocks in it. You are getting tired. You can take a big rock out of your pack and keep going – but the race will get a quarter mile longer… Or you can take smaller rocks out every quarter mile and finish sooner… and end up carrying less weight overall.
Now, there are two things to watch out for in paying off debts.
The first is tax deductibility. Many people keep around things like mortgage loans because they are tax deductible. However, the deduction for a mortgage loan is only a percentage of the interest you paid on the loan. At best, you should think of it as reducing the interest rate on the loan by about 20%. So, if you had a mortgage with a 10% interest rate then you could deduct 20% of that and say that your mortgage rate is actually closer to 8%. When you look at it this way, you can see that while a mortgage is generally one of the last things you want to pay down when trying to get out of debt (because of the generally low-interest rate to start) you shouldn’t avoid paying it down just to save the tax deduction.
The second thing to avoid at all costs in seeking a loan is one in which you cannot pay in advance against the principal to reduce your debt. Here’s why. Some lenders will specify that you cannot make extra payments against the principal. They will take a payment and treat it as reducing the last payment on the debt. So, you are paying off the debt faster, but you are not saving on any interest until the end of the debt.
Let’s see how this is different.
You owe a lender $100.00. He is charging you 10% interest per month and he wants you to pay off the debt in ten months. You will be paying $10.00 towards the principal each month. So, the first month you pay interest on $100.00. The second month you pay interest on $90.00. And so on…
Now, Let’s say in the third month you receive an extra $10.00 bonus and include it in the payment to reduce the debt. Here’s the difference. If the loan were paid off normally you would see payments that look like this.
100 90 80 70 60 50 40 30 20 10
+10 10 10 10 10 10 10 10 10 10
+10 9 8 7 6 5 4 3 2 1
+20 19 18 17 16 15 14 13 12 11
Those would be your payments and the interest
The top row is the principle.
The second row is your $10.00 payment against the principle the lender wants.
The third row is the interest payment on the principle for that month
The fourth row is what your payment would be every month until the debt is gone.
It’s pretty straightforward.
Now let’s take a look at what happens when we add that extra $10.00 payment in the third month.
If the lender pushes the payment to the end of the month your payments would look like this.
100 90 80 70 60 50 40 30 20 10
+10 10 10 10 10 10 10 10 10 10
+10 9 8 7 6 5 4 3 2 0
+20 19 18 17 16 15 14 13 12 10
You have eliminated the final payment but you continue to pay on the principal until the debt is discharged. You paid $10.00 extra and shortened the loan time but you saved very little ($1) in interest.
Now look at what happens when you apply that to the principle.
100 90 80 60 50 40 30 20 10 0
+10 10 10 10 10 10 10 10 10 0
+10 9 8 6 5 4 3 2 1 0
+20 19 18 16 15 14 13 12 11 0
Not only do you pay off the debt one month faster, you actually pay substantially less money! You actually saved $1.00 for each month from that payment point. So you end your debt one month early and you saved $7.00 in interest. See the difference?
Now, in the real world what would happen is that the amount you pay differs based on the kind of loan you have.
If you have a mortgage, the amount you pay is fixed and you initially begin paying off only a small piece of the interest at first. The lender applies a certain amount of the interest and a certain amount towards the principal in a complicated formula designed to reduce your debt over a fixed amount of time. As your payments progress, you pay less and less interest and more and more in principal until near the end almost the entire payment is going to principal. If that is the case, making extra payments on the debt is most beneficial the earlier you do it. Near the end of the debt, you are paying primarily towards principal anyway so you are only shortening the time until the debt is paid off. If you pay extra at the beginning of the debt you reduce the principal and not only pay off the debt faster but reduce the interest payments creating a snowball effect of paying more and more towards the principal reducing the debt even further. For large loans, paying early on principal can snowball into tens of thousands of dollars of savings overall. In our example above you saved about $7.00 as well as ending a month early. With a standard fixed payment, the picture would be more complicated but the early payment would have a huge effect in reducing the time and payment.
Another way to reduce debt is to split payments in half and pay half early. So, if you have a mortgage payment of $1000.00 and you make two payments of $500.00 in the middle and end of the month you will save thousands over the course of the loan rather than paying the full $1000.00 at the end of the month. This is because you have reduced half of your normal principle payment 15 days early each month. Again, switching to bi-weekly payments at the end of a mortgage does little to reduce your debt since you are paying primarily on principle at that point anyway, but doing it from the beginning of a new mortgage can result in substantial savings.
The second kind of loan you can receive is one where the payment is not fixed but adjusts with your indebtedness. Credit cards are the typical example. Each month the amount you are asked to pay shifts based on how much you owe. The debt includes all the interest on the debt plus some portion of the principle. The credit card will generally offer a date as to when the card would be completely paid off and how much it would cost you if you stopped using the card and focused on paying off the debt. It can be pretty disheartening to see just how much your credit card debt is eating up your cash. And if you have more than one card it can be scary trying to figure out how to pay them off.
At the bottom line though when trying to pay off debt one rule applies. Interest rate pushes everything. To get out of debt pay off the biggest interest rate debt first. If you do you’ll be a winner!
David Dougher – author, ballroom dance instructor, computer consultant, game designer, and odd fellow.
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