Which account balances should consumers pay off first to become debt free?
This is a question that polarizes camps from different sides. If you had $300 extra each month to apply towards debt elimination you would want to follow the process that works the best. There are two popular beliefs:
- Pay extra on the highest interest rate first
- Pay extra on the lowest balance first
Pay extra on the Highest Interest Rate
This process is most efficient. Interest is charged on the outstanding loan balances, so sending $300 extra to a 19% credit card will charge less interest next month than applying the extra to a 3% car loan. Less interest is a good thing.
Pay extra on the Lowest Balance
This method is not mathematically as efficient as the Highest Interest Rate process. It requires extra payments to be applied towards the debt with the lowest payoff balance, not necessarily a debt that charges interest at a higher percentage. This is more commonly known as the Debt Snowball Method.
They both work in theory, but which one works best?
Two researchers from Northwestern University, David Gal and Blakeley B. McShane, obtained access to a unique data set that gave precise information as to how 6,000 people finally eliminated their credit card debt. Researcher Gal said:
“We found that closing debt accounts, independent of the dollar balances of the closed accounts, predicted successful debt elimination at any point in the debt settlement program”
The survey says…
Reducing balances or paying less interest were not the leading factors of success, it was getting the accounts closed!
Accomplishing little goals motivates people to continue in a process that appears to be working, like checking things off a To-Do list.
The sad truth is that Americans aren’t diligent enough to stick through a process that will cause them to pay less penalties (interest).
The good news is the Debt Snowball Method has a better success rate of keeping people in the game – all the way to the finish line!
A visual representation of how it feels
Using an awesome excel spreadsheet from Vertex42 we can compare the differences between the two methods and see the true net effect.
This couple has a New Year’s Resolution to start the process of paying off $45,035 in debt after the ball drops in Times Square. They have $1,200 a month to put towards their goal, $261.77 of which is used to attack their six debts after the $938.23 in minimum payments.
Doing it by the numbers
Following the traditional advice, this couple would pay their minimums and then apply all their extra money towards their highest interest debt – a 22.99% credit card.
Continuing this process every month will give them their first win (paying off the card) in nine months.
Once it is gone they can take the minimum payment of $48.69 and the extra $261.77 and apply it to the next debt on their list – their “Chasing” credit card.
This debt will be eliminated in another twelve months (a total of 21 months after beginning the process). Keep attacking the debt in this manner and they will have the last debts paid off in July 2016 and have paid $5,228.07 in interest charges.
The math doesn’t work!
If your goal is to pay the least amount of interest, then staying out of debt completely is the best way!
However, most Americans accept debt as a way of life until they get a wake-up call when they get laid off, someone dies or is born, or they realize retirement is on the horizon.
Math alone does not get people out of debt, people sticking to a plan get out of debt.
Staying motivated is the key
Now they have the extra cash-flow to attack the next smallest debt and the second one is knocked out in another eight months.
They are more likely to continue the process because they feel they are making progress.
There are some side effects to following a Debt Snowball plan like this one – some are good and some aren’t as bad as people make them out to be:
- They will pay more interest, but only $392.97 more – that’s less than .9%. Considering this couple paid off $45K in debt, that’s not as bad as the financial “sophisticates” make it out to be
- They will get out of debt one month later. Hey, they lived with the debt a long time, they can manage one more month if the process works
- The 0% credit card was paid off quick enough to avoid the rate increase. Most “Introductory Offers” have a short time span, so the side effect of being paid off sooner is that it didn’t jump in rate
- The car got paid off sooner. Wha? Yep. Even though the car came 5th in both scenarios, it gets paid off in April 2016 instead of July 2016
- This couple will be better prepared for emergencies. By knocking off some of the debts sooner they have more money available to them if something bad happens. It is better to postpone your debt snowball and pay through emergencies than go back into debt again
So what is the best way to eliminate debt and become free again, like we were before we had credit cards and car payments or Lines of Credit at the bank? The research is in and the Debt Snowball Method won!
What happens to the cash envelopes when you move to the YNAB software? That was the question Brett asked me this week. Cash envelopes are still important for food, clothing, and entertainment but keeping stashes of cash for house repairs or a quarterly car insurance payment just doesn’t make sense. I suggest doing one of the following:
- Make separate deposits for any envelopes you would feel are better to have in the bank. In YNAB, enter each deposit as an Inflow total instead of Outflow for the appropriate category. It’s kind of like un-spending something but it has the same effect as increasing the buffer for that item
- Deposit the cash and enter it into YNAB as income for this month. Then budget the money as you see fit. This is probably the easiest of the two