Get Out of Debt

get out of debt
by roberthuffstutter

Get Out of Debt

Deciding to get out of debt is the first step, how to get of debt is the second step. The only way to get out of debt short of winning the lottery is to have more income than expenses. If this is not the case then something has got to change!

Let us assume that you have made some changes in your life style and you now have more income than expenses. The amount of extra income that you can pay toward the principal will be determined how quick you get out of debt.

Now this is where the interesting part starts. There are five ways you can apply this extra amount to your debt.

You could divide the extra amount equally among all your loans, but unless you have a very large amount available or only one or two loans, this would take the longest to pay off your debt.

The next two are almost as bad, paying off the highest amount first or paying the lowest rate first.

The two remaining options are the ones most discussed in clearing up debt. Paying highest rate first and paying the lowest amount first.

There is not a lot of difference between these last two options and it depends on how the debt is distributed and how much you have to apply as to which one gets the job done first. However, we are only talking about a few months difference between the two.

Paying the highest interest rate loans off first:

If you listen to most, any talk show on money, this is the advice they will give.

Let us look at someone with $ 100,000 of debt not counting any home loans, say seven credit cards, two car payments and some other strange loan. Interest rates range from 4% to 23%. As most of the payments go toward the interest, we will assume that the principal will only go down by the amount of the extra payment we can make.

As each loan is paid off, we apply the available funds to the next loan and so forth.

Here are the two examples that I compared:

Debt
Credit Amount Rate
Card #1 $ 10,000 23% $ 242
Card #2 $ 3,000 22% $ 70
Card #3 $ 4,000 21% $ 90
Card #4 $ 5,000 20% $ 108
Card #5 $ 2,000 18% $ 40
Card #6 $ 1,000 12% $ 15
Card #7 $ 20,000 7% $ 217
Car #1 $ 27,000 6% $ 270
Car #2 $ 22,000 5% $ 202
Other $ 6,000 4% $ 50
Total Debt $ 100,000
Total Monthly Payments $ 1,303

Example 1

Credit Amount Rate
Card #1 $ 2,000 23% $ 48
Card #2 $ 800 22% $ 19
Card #3 $ 1,600 21% $ 36
Card #4 $ 3,200 20% $ 69
Card #5 $ 400 18% $ 8
Card #6 $ 200 12% $ 3
Card #7 $ 12,800 7% $ 139
Car #1 $ 47,000 6% $ 470
Car #2 $ 25,600 5% $ 235
Other $ 6,400 4% $ 53
Total Debt $ 100,000
Total Monthly Payments $ 1,080

Example 2

Interesting things happen when we apply different amounts each month toward paying off the debt.

I first assumed we had $ 100.00 extra to apply and found that in Example 1, by paying off the highest rate first it would take 217 months or 18 years to get out of debt. Compare this to paying the high amount first, 33 years and paying the lowest rate first, 27 years. Paying off the lowest amount first was 220 months or 18 years. The actual difference was only 2.6 months. In Example 2, by paying off the highest rate first it would take 244 months or 20 years to get out of debt. Compare this to paying the high amount first, 45 years and paying the lowest rate first, 31 years. Paying off the lowest amount first was 254 months.

Now assume that we have $ 200.00 extra to apply. Example 1, paying the high rate first takes just 13 years. Paying high amount first takes 20 years. Paying lowest rate first takes 27 years. And paying off the lowest amount first takes 14 years. Example 2, paying the high rate first takes 15 years. Paying high amount first takes 25 years. Paying the lowest rate first takes 31 years. And paying off the lowest amount first takes 16 years.

Now assume that we have only $ 50.00 to apply. Example 1, paying the high rate first takes 27 years. Paying high amount first takes 57 years. Paying lowest rate first takes 27 years. And paying off the lowest amount first takes only 23 years. Example 2, paying the high rate first takes 25 years. Paying high amount first takes 85 years. Paying the lowest rate first takes 31 years. And paying off the lowest amount first takes 26 years.

So I would tend to agree with most talk programs that paying off the loans with the highest interest rate would be best unless that highest rate loan was also your largest loan. The higher the amount on the high interest rate loans shifts the advantage to paying off the lowest amount loan first.

Paying the lowest balance loan off first:

There is one radio host who does push paying the lowest balance off first and in all cases. The reason is simple, if you do not see progress in clearing up your debt you will become discouraged and stop. This is true in just about anything, we need the short term rewards. In service work we tried to knock out the simple repair jobs first. If we started with the tough ones we would become bogged down and the work load would back up. By keeping the small jobs cleared out and then working on the tough ones we could stay caught up. The same is true when we try to get out of debt. Pay off the easy ones first then work on the bigger debts. As you can see by the examples, the time frame of paying off the lowest balance first is not much different from paying off the highest rate first.

It is more important to stay on target and get all the debt paid off as soon as possible. Continue to pay down the debt with the payments you were making even after each debt is retired. Look for extra funds to apply to the balances. When you get down to one loan, the payment will be so high that it to will drop quickly. The goal should be to increase the amount you are paying as fast as possible. So no matter how small, pay it off and then use those payments to attack the next loan.

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