I have a bunch of loans (credit cards, line of credit, student loans). Which do I pay off first? Does it matter what order I choose?
The order in which you pay off your loans does matter and, from my experience, there are two schools of thought about how best to pay off your debts. One approach focuses on the best financial way to pay off your loans (the approach that saves you the most money) while the second approach strives to provide emotional encouragement.
Let’s look at the better financial approach first which is the one most people will recommend. To save yourself the largest amount of money and pay off your loans as quickly as possible, identify the loan with the highest interest rate and focus on paying that one off first. You should still continue to make small payments (most loans have a minimal monthly payment) on your lower interest loans, but put as much money as you can toward the highest interest loans. Once the highest interest loan has been paid, then focus on the one with the next highest interest and pay it off. Keep repeating this until each loan is paid off.
Some people instinctively feel they should focus on the loan with the largest or smallest amount owing and pay it down. (The smallest owing so it gets paid off quickly, reducing the number of loans. The highest amount owing because it looks like it’s the more formidable.) Try to ignore that impulse and focus on the loan with the highest interest. Let’s look at an example of why that is.
Pay the highest interest loan first
Imagine you have two loans, a big one and a small one. We’ll use nice, round numbers to make this straight forward. Let’s say your small loan is $5 and it charges 40% interest per year. The big loan is $100 and charges 1% interest per year. (These are silly numbers and are just for the purpose of a demonstration.)
Now let’s say you have $2 per month to use to pay down your loans. If you focus on the big loan first (the $100 at 1% interest) it’ll take you about 52 months (just over four years) to pay off the $100 loan. Due to the interest, it’ll cost $102 to pay it all down. By the time you’re done paying off that first, big loan, your $5 loan will have grown to about $19.25. This $19 will take about a year (12 months) to pay at $2 per month. In total, to pay off both loans you’ll have spent just over $121 over the span of 64 months (about five and a half years). This is tackling the big, low-interest loan first.
What happens if you pay off the tiny $5 loan at 40% first? Paying off the little $5 loan takes just three months and costs about $5.30. During that time your big loan has only accumulated about $0.08 of interest, having almost no effect. You’ll still pay off the larger loan in 52 months. This means tackling the high-interest loan first, even though it’s smaller, results in you paying off both loans in 55 months at a total cost of $107.
Paying off the high interest loan first saves you $14 and takes 9 fewer months. Granted, this is a simple example with made up numbers, but I think it demonstrates the point. It’ll work the same way if the loan amounts are a hundred or a thousand times larger. So if your primary concern is saving yourself time and money, then get rid of your high interest loan first and then tackle the next highest.
Pay the smallest loan first
Earlier I mentioned there were two approaches that people recommend. While the first approach saves you the most money, it is sometimes difficult for people to stick with a financial plan if doesn’t look like it’s having an effect. Paying off a high interest loan first and then moving to the next one makes good financial sense, but it can take a long time and it takes discipline. Some people want to feel like they are making a difference, they want to see they are accomplishing something.
For people who need to see progress in order to feel good about their efforts it can make sense to tackle the smaller loan first, then the next smallest, then the next smallest. This wipes small loans out more quickly and gives a sense of accomplishment. It may cost more in the long run, but it can keep the borrower focused on making repayments.
As an example, let’s say you had three loans: $100 at 1%, 50 at %20, and $20 at 10%. The most efficient approach (which I mentioned first) would be to pay off the high-interest loan first ($50 at 20%). However, with this second approach that gives a sense of progress you’d pay back the $20 loan first, then go after the $50 loan. This will end up costing slightly more, but knock one loan off the board sooner, given a sense of accomplishment.
Other approaches to consider
When paying off loans what really hurts people is high interest rates. If you were paying off a $1,000 loan at a 10% interest rate and you were making monthly payments of $50 then it would take 22 months to pay off the loan and it would cost a total of $1,098. So $98 in interest.
The same loan principal of $1,000 at 25% takes 27 months to pay down and costs $1,307. That’s $209 more and almost half a year longer to pay back the same $1,000 you originally borrowed! Obviously you want the lowest interest rate possible.
Credit cards and pay day loans often have interest rates over 20% and this can make them difficult and expensive to pay down. However, banks and credit unions will often provide you with a low interest line of credit or personal loan. These can range from around 5% to 12%. This can cut your monthly payments in half and greatly reduce the total cost of paying back a loan. Paying off one or more high-interest loans with one big, low-interest loan is called debt consolidation and it’s a relatively easy way to reduce the time and money it’ll take to pay off multiple loans.
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