Thursday, August 20

Climbing Out of Debt

As I have alluded in previous posts, Adam and I accumulated quite a bit of consumer debt while he was out of work for a year and a half. We are finally poised to actually start paying some of it off, rather than just making minimum payments to each account.

Being the analytical person I am, I wasn't content to simply follow a single strategy because some financial expert or another recommends it. I need to do things the hard way and find out for myself why they work (or don't). I'm beginning to realize just now how challenging that single trait must have been to my parents, since my daughter is exactly the same way, but that's a post for another day.

In any case, I had two basic theories to test. I have read debt-repayment plans that suggest paying off credit cards and loans based on both the interest rate (paying off high-rate loans and working your way down to lower-rate ones) and debt size (eliminating the smallest debts first so you can increase payments to your larger loans more quickly). For some, these may be the same--their lowest interest loans may be the largest. Unfortunately, that isn't the case for us.

So, I spent an hour or so gathering up all my interest rates and minimum payment numbers, then entered everything in a spreadsheet for comparison. Calculating both the interest-based repayment and debt-size repayment options, I discovered something which surprised me. While the interest-based strategy does pay off slightly faster, the total repayment difference between the them was just two months out of a five-year plan or about 3% over the life of the loans.

Depending on how your own debt is organized, you might find some differences in the exact numbers, but I honestly have to say that either repayment plan is a good one. Using the high-interest strategy, you may save a few dollars, but if your debt is poorly arranged (like ours), you end up paying off multiple lenders for a much longer time. By paying off the smaller debts first, you can eliminate several debts more quickly, which has a great motivational effect, but it may end up costing a little more money overall.

For those of you who may not enjoy long division in your spare time, but would like to see how these numbers actually work for your own debts, let me share the formula I used to figure out how long it would take to repay each loan. If anyone is interested, I can make this formula available in Excel so you can plug in your own numbers. Just send me an e-mail or leave me a comment to that effect. You can download a sample spreadsheet in Excel to plug in your own set of numbers.

The amount you owe
+ The finance charge (APR ÷ 12 x the amount you owe)
- Your monthly payment

That will tell you your new balance due after one month. Repeat the same formula for the second month, but make sure you change the amount you owe to indicate the new monthly balance.

When working with multiple debts, remember when one is paid off, you then adjust the monthly payment to your next highest interest rate (or smallest balance due) to include the additional payment amount available from the debt that has been eliminated.

3 comments:

  1. Do you have the excel already worked up? I don't want to make you work hard just for me, but that would be cool to actually SEE the numbers for our debt. I don't calculate interest when I make our debt repayment plans and that might help if I knew such things as that.

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  2. I've been playing with this for a good half an hour now. (Excel and I are not friends. I am an art major, not a math major...) Verrrrry interesting. Looks like if I shift around some of the payments I'm making, I can be out of debt — including the mortgage! — in four years. Hmmmm....

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