Debt Payment Optimization

Personal debt comes in all shapes and sizes. Most commonly, families will carry debt on their home (mortgage), transportation (auto loan), education (student loan), and lifestyle (credit card).

This is not good.

Often times, I will read the debate on “good debt” vs. “bad debt.” Most will explain how taking out a mortgage is good, while carrying a balance on your credit card is bad. This stance is on the right track, but I still don’t agree that a mortgage is necessarily a good thing (credit card debt is definitely a bad thing, however).

Debt takes room in our budgets and forces us to spend money on interest payments instead of living a life of financial freedom. Don’t be fooled, the bank owns your home until you are 100% mortgage free. They are not very forgiving if you miss just one of your 360 payments on a 30-year mortgage.

Now, understanding that most families carry some form of debt (good or bad), there needs to be a plan of how to pay down this debt as quickly as possible. I have put together a sample client scenario that has a few various debt payments to navigate within their financial plan.

Should they stick to the standard payments for each individual debt, or reallocate their payments to supercharge their debt payments?

Sample Case

John and Jane Doe are a married couple in their mid-30s, both with great careers and a growing family. However, over the years they have taken on various forms of debt as their lifestyle continues to grow and evolve. Here are their current liabilities:

  • 30-Year Home Mortgage: $175,787 balance, $952 monthly payment, 4% interest rate
  • Car Loan (John): $17,500 balance, $395 monthly payment ($200 minimum), 2% interest rate
  • Car Loan (Jane): $24,325 balance, $299 monthly payment ($299 minimum), 6.5% interest rate
  • Student Loan (John): $45,722 balance, $475 monthly payment ($50 minimum), 6.9% interest rate
  • Student Loan (Jane): $13,261 balance, $262 monthly payment ($50 minimum), 3.86% interest rate
  • Credit Card (John): $7,500 balance, $200 monthly payment ($25 minimum), 15.74% interest rate

Keep Current Payments

Current payments total $2,583 per month with the final payment being made in January 2041 (mortgage already started).

The current payments scenario assumes that as each individual debt is paid off, you begin spending the money you had allocated to that debt elsewhere. For example, when Jane finishes paying off her student loan, she spends the $262 per month instead of using it to pay down her remaining debts.

This is the most common route I see taken, as the individuals feel a sense of “relief” when they don’t have to make that debt payment anymore and can go back to being a consumer. Unfortunately, this not only extends the period of time they will remain in debt, but also increases the risk of “debt relapse” or getting back into debt by buying more stuff.

Reallocate Payments - Lowest To Highest Balance

This strategy has famously been coined the “Debt Snowball” by Dave Ramsey. To execute this strategy, as you pay off your lowest balance debt, you reallocate that monthly payment to the next lowest balance. Here’s how John and Jane would play this out:

John and Jane’s lowest balance debt is John’s Credit Card. As soon as John completely pays off this loan, he will take the $200 monthly payment and reallocate it to their next lowest balance, Jane’s student loan. Now Jane’s monthly student loan payment will be $462 (200 + 262). Once Jane’s student loan is paid off, they will take the $462 payment and reallocate it to pay off John’s car loan (this payment becomes $857).

As you can see, as each debt is paid off, the amount going towards the next lowest balance continues to increase (creating a snowball effect) until each debt is paid off. This will allow John and Jane to feel a sense of achievement and feel motivated to continue paying off each debt quickly, instead of using the lack of monthly debt payments to increase their lifestyle.

 

Verdict: Savings of $46,974 and debt free 145 months sooner!

 

Reallocate Payments - Highest To Lowest Interest Rate

While the Debt Snowball strategy is great, this strategy is even better. Paying off your balances with the highest interest rate first will allow you to save money on total interest paid over the course of your debt payment lifetime.

Similar to the Debt Snowball strategy, once a debt is paid off, you will reallocate that monthly payment to the next debt on the list. However, this strategy prioritizes the payments by interest rate, instead of balance.

Here John and Jane will begin by paying down their highest interest rate balance first, John’s credit card. Once John’s credit card is paid off, he will reallocate the $200 monthly payment and put it toward John’s student loan (next highest interest rate). Now John’s student loan payment will total $675 (200 + 475) until it is paid off. This reallocation will then go towards the next highest interest rate until each debt is paid off.

 

Verdict: Savings of $52,546 and debt free 147 months sooner!

 

Attack Your Debt

By utilizing either of these debt payoff strategies, John and Jane will be saving thousands of dollars in interest payments and be financially free from debt over 12 years sooner!

For a couple in their mid-30s, this can easily mean the difference between an early retirement and working well into their 60s or 70s, because they still have debt to pay off.

As a reminder, over the course of these debt payments, there was never an increase in total monthly payments. John and Jane maintained the same total monthly payment of $2,583 until all debts were paid off. They simply reallocated each payment until every debt was fully paid off, instead of increasing their lifestyle as they went along.

You need to have a plan to optimize your debt payments, whether that’s by creating quick “small wins” with the Debt Snowball strategy, or choosing to attack the highest interest rate debt first. Reallocating your debt payments will get you on your way to a debt-free lifestyle before you know it.

 

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