Wake Up with Wealthtender: July 3, 2020
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We’ve all been there. Student loans to help pay for tuition. A business loan to help rent an office space and furnish it before you see any paying clients. Credit card debt to cover expenses while you start building your practice. It’s tough to get your education and start a practice (or any other business) without incurring debt, and usually many sorts of debt.
When I started my post-doc (more years ago than I like to think), I had just moved to the US and borrowed $6000 at 10.4% (!) interest to buy a used car. Paying nearly $200 per month isn’t easy on a $31,000 salary. Especially when that salary needed to pay the rent and put food on the table for my family. That’s how I know the financial and psychological toll owing money takes.
If you too have more debt than you’re comfortable with, what’s the best way to pay it all off? It turns out there are two “best ways” to pay off debts, and your personality determines which one you should pick.
Think of money like a river, with interest like a current you have to overcome. To pay off debt, you have to paddle against that current. If you don’t paddle fast enough, the current will carry you further and further downstream. In financial terms, if you pay less than the interest on what you owe, you fall deeper and deeper into debt.
There really are two best strategies for paying off your debt.
If you read carefully, you noticed that the two strategies are similar. Each time you retire your current “target debt,” you add what you paid against it to your next target.
The difference is the order of picking those targets. The first method has you targeting the one with the highest interest rate. In the second, it’s the remaining one with the lowest balance.
In both cases, as you retire more debts, you pay ever-growing amounts to your next target debt, retiring those ever more quickly.
The first method is like the kayaker choosing to fight the strongest current first, knowing it’ll get progressively easier after that. In financial terms, the quicker you pay off higher-interest debts, the less time those debts incur their higher cost.
The second method is like our kayaker working on the easiest current first. This lets him build up his paddling skill and endurance, making it easier to tackle stronger currents later.
If you were a robot or computer, the first strategy would always win. However, most people find the second strategy easier to stick with. Behavioral finance research shows you’re more likely to keep up with a difficult program if you experience early success.
To choose which method is best for you, ask yourself, “Am I disciplined enough to stay the course even if I don’t see the evidence of success (retiring a debt) early, or am I more likely to stick with it if I have such an early success?”
If you feel disciplined enough to stick with the harder rowing, choose the first method, targeting the highest-interest debt first. This will minimize your overall interest cost.
However, if you’re not sure of your discipline, target the lowest-balance debt first. That’s because it’s worth paying a bit more interest if it keeps you paddling until you reach your target.
So, which method is right for you?
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.