0

Supposed you have a fixed amount of money to commit every month to debt repayment... well above all minimum payment requirements. All other quirks and conditions being equal. The only differences are the interest rates and the balances. That said, Ive frequently seen it written that the best way to pay off your debts is to pay minimums on all but the highest interest rate loan, where you dump any surplus money.

But I am wondering if this is necessarily the optimum way of doing it?!?!

Doesnt it make more sense to pay off whichever loan is accruing the most in interest every month in terms of dollar amount? Not percentage. i.e. the product between balance and interest rate. Or am I wrong about this?

0
2

The wisdom that you have "frequently seen written" is in fact correct.

You must pay off at least the minimum required amount on each of your loans and credit cards. If you have further surplus cash available to pay down your debts, your best option is indeed to pay off the loan with the highest interest rate.

If one loan is accruing more interest each month because that loan has the highest balance you should ignore that fact. You should be looking at how to get the "best bang for your bucks". The question becomes: Am I better off using my spare (say) $1000 to avoid paying interest at 21% per annum on my credit card - or am I better off using my spare $1000 to avoid paying interest at 10% on my car loan?

You can reduce your interest charges in either loan by paying the balance down - but you get a bigger reduction in interest charges by paying down the high-interest-rate loan.

If you still need to convince yourself, try modelling it out in a spreadsheet and compare the total amount owing after making optional repayments under various scenarios.

2

No, you are incorrect in your reasoning. As you pay down a loan, you reduce the interest you will pay in the future. For simplicity's sake, let's assume you have two debts:

  • A credit card debt of $30,000 which is charged 20% interest per year
  • A mortgage loan of $300,000 which has 3% interest per year.

To keep our example simple, we'll assume that you make one payment to each loan per year and the minimum payment is just whatever interest is accrued.

Assuming you pay the minimum, you'll owe $9000/year of interest on your mortgage and $6000/year on your credit card for a total of $15,000 in interest. Now let's say beyond the interest you have another $3000/year to spend on paying down your debts. If you put that $3000 toward your credit card debt, next year (and every year in the future) you'll still have $9000 of interest on your mortgage but you'll only be charged the 20% interest on $27,000 worth of credit card debt which comes out to $5,400 on your credit card interest. You have permanently reduced your total annual interest by $600 (or 20% of the $3000 you invested in paying down your debt). Next year, if you still have the same $18,000 to pay toward your debt, you'll spend $14,400 on interest and you can reduce your credit card debt by $3600. This will continue to accelerate as you pay down your debt.

On the other hand, if you were instead to use that $3000 toward your mortgage, next year you'd reduce your total interest by only 3% of the $3000 (just $90). You'll barely be reducing your interest payments at all, so the money you spend each year will continue to go toward interest rather than paying down the principal.

Year-after-year if you keep doing this, the benefits of paying down your loans compound. If you pay down the high interest loans first, you'll save much more over time

1
  • A simpler view: You have a $30,000 loan with 20% interest and 10 $30,000 loans with 3% interest. Which one do you pay off first?
    – user253751
    Jul 27 '20 at 12:11
0

The important thing to understand about debt and interest rates is that for repayment prioritization (when the goal is paying the least interest) the balance doesn't matter. It may be beneficial to think of many $1 loans instead of a few larger ones. Having one $100,000 loan at 4% is the same from an interest perspective as having 100,000 $1 loans at 4%. Having $5,000 at 8% accrues interest the same as having 5,000 $1 loans at 8% (well, there could be a very small difference due to rounding and their inability to collect fractional pennies, but as far as the math goes without rounding, identical).

If you think about your debt in this way then with each extra dollar you can either pay off one of your $1 at 8% loans or one of your $1 at 4% loans. When the loans all have the same balance it becomes clear that paying off the higher rate first is better, and it holds true even when the balances aren't the same.

It's also worth noting when prioritizing debt that you need to evaluate effective interest rate rather than stated interest rate, since some debts are tax-advantaged. Also worth noting that there can be compelling reasons to pay off debts in other orders, it's just that mathematically the best way to reduce total interest paid is to go highest effective rate first.

Not the answer you're looking for? Browse other questions tagged or ask your own question.