There is a subtle art to paying down debt. Most folks don’t know there is a mathematical science to this art. On our journey for financial independence, I discovered certain truths that are self-evident really don’t pass muster under deeper scrutiny. Debt management is the 2nd of 6 steps to financial security. Debt management includes consolidating and eliminating debt. The other steps include increasing cash flow, having an emergency fund, proper protection, building wealth, and preserving wealth. Let’s go through some common myths.
Focus on one debt and pay the minimum on the rest
Myth #1: Pay extra to every debt monthly
By focusing on one debt, you are concentrating your financial firepower to pay down principal faster. When your principal goes down faster, you pay less interest over time. Choose a debt to pay down, then pay the minimums on the rest.
Focus on snowballing debts
Once you finish with one debt, take the payments you were making (as we discussed here), and add it to the payment of the next debt. This is common advice, and it is correct. Similar to a snowball rolling downhill, the payment towards debt gets bigger the more debts you pay off.
Make extra large payments every few months
Myth #2: Pay extra towards debt every paycheck or month
This one seems counterintuitive. It’s based on two factors, most debt compounds interest daily, and large payments pay more towards principal than interest. It compounds, daily. I bet you didn’t know, but you are charged interest every day you have a credit card or certain loans. Every day you pay interest, then pay some more interest on the interest you already owe. It’s not simple interest, although the banks like to make it seem that way.
The key to paying down debt is paying down the principal. If you were considering paying $100 a month extra towards some debt, consider paying $300 now, and skipping the extra the next two months. Repeat the process until the debt is paid off.
Find a way to reduce lifetime total interest
Myth #3: Pay the debt with the highest interest rate first
I discovered this is the most important point of all, and the hardest to figure out. Common wisdom says to pay off the one with the highest interest. The math shows you need a comprehensive plan to minimize your total lifetime interest and number of years to pay your debt. This depends on which debt you pay first, how much you pay, when you pay, and which debt to snowball next. By minimizing your lifetime interest, you will get out of debt faster and with less out of pocket.
If you have credit cards, student loans, private loans, a mortgage, and car payments, how do you know which debt to pay off first?
– smilingdad
Stop digging!
The key to getting out of debt is stop adding more debt, and increasing your cashflow to pay down your debt faster. If you keep piling on more debt, even as you pay down other debts, you are putting yourself under more and unnecessary stress. You can increase cashflow by cutting expenses (so hard) or by earning more income. I suggest learning more, investing in yourself, and earning more income. Keep your mind engaged.
What debt would you pay off first?
Suppose you have three debts, one is $4,500 at 15% interest, another is $18,000 at 8%, and the last is $63,000 at 5%. You were able to save $4,500 over the course of a year. What debt do you want to put the money towards?
| Debt amount | Term | Interest | Monthly Payment |
|---|---|---|---|
| $4,500 | Revolving credit | 15% | $90.00 |
| $18,000 | 5 year fixed personal loan | 8% | $364.94 |
| $63,000 | 15 year mortgage | 5% | $498.18 |
Many would say pay off the credit card. Let’s see what the math says. Excel has a great function called CUMIPMT. This function returns the cumulative interest paid in between two periods. For the revolving credit, the actual total is $2,603.31 in interest paid over 80 months. Using CUMIPMT(15%/365,2400,-4500,1,2400,1) I get $2,576.14. Excel will walk you through what each term means. In the formula, we are taking 15%, dividing it by 365 to get the daily interest rate, then getting the interest on $4,500 for 2400 days. This is a good approximation, about 1% off of the true total.
| Debt amount | Cumulative Interest |
|---|---|
| $4,500 | $2,603.31 over 80 months |
| $18,000 | $3,896.14 over 60 months |
| $63,000 | $26,654.03 over 180 months |
Now, BAM! we make a payment of $4,500. How much is the interest reduced?
| Debt amount | Old Cumulative Interest | New Cumulative Interest | Difference |
|---|---|---|---|
| $4,500 | $2,603.31 over 80 months | $0 | $2,603.31 saved |
| $18,000 | $3,896.14 over 60 months | $2,091.70 | $1,804.43 saved |
| $63,000 | $26,654.03 over 180 months | $22,024.26 | $4,629.77 saved |
This leads us to believe putting the money towards the mortgage makes more sense. We save more in interest than our principal payment (over a 100% return on investment) and we save 1 year of mortgage payments. We have to wait 14 long years for the payment to realize the results. During that time, we continue making payments on the revolving credit and fixed personal loan. Common sense tells us that’s not what most people should do. Below, I go over three options to pay off the debt.
| Plan | Cumulative Interest | Cumulative Payments | Total | Total years of payments |
|---|---|---|---|---|
| A – No extra payments | $33,153 | $118,654 | $151,807 | |
| B – $4,500 towards CC, then snowball loan, then snowball mortgage | $20,952 | $85,456 | $106,409 | 9 years |
| C – $4,500 towards loan, then snowball CC, then snowball mortgage | $22,381 | $107,881 | $130,263 | 9 years |
Clearly, option B and C is superior to the original option in terms of time and dollars spent. Option B is superior to Option C by having similar time to pay but lower total payments. In this case, the conventional wisdom is right, pay the high interest credit card first. This is one payment of $4,500. We saved 6 years in payments and $45,000 we would have sent to the bank.
What happens if we could put aside $4,500 once a year? What happens if we can stop making bank executives rich and enrich our own lives? There is an opportunity cost to debt, as we discussed earlier in the week. Many of you will ask, smilingdad, if we can earn more money than the interest rate on the debt, does it still make sense to pay it off? We’ll cover that next post.
Sustainability and saving money
If you have minimal debt, there are other ways to save money and help the environment at the same time. I am passing along two articles from a fellow Cleantechnica writer, Scott Cooney.
Home Efficiency 101: Appliances, Thermal Envelope, Lighting, Plumbing, & More
Maintenance Tips For A Green Home
Sign up for when we publish our next post.
Thanks for reading!
Warmest regards,
smilingdad
smilingdad 
One thought on “The Art of Paying Down Debt”