Getting out of debt tops the list of Americans’ financial priorities, according to a recent study by BMO Wealth Management. If getting out of debt is one of your top goals, two simple steps will speed up the process.
- “Fix” your payments
Credit-card companies are incredibly kind. Did you know that? If you always make the minimum monthly payment required, your minimum amount due will decline each month that follows (assuming you go no further into debt). Isn’t that nice of the credit-card company? Who else that you owe money to asks for less each month?
Of course, it isn’t kindness; it’s math. Your minimum payment is based on a percentage of your balance, and if your balance goes down a little each month, so will your required minimum payment. The problem (for you, not the credit-card company) is that paying this declining minimum each month will keep you in debt for a very long time.
For example, let’s say you have a $4,000 balance on a credit card that charges 18% interest and requires a minimum payment of 4% of your balance or $15, whichever is higher.
This month, your minimum payment will be $160. Assuming you don’t add any more debt, next month it’ll be $156.00, then $152.10, and on and on. If you take this declining minimum-payment route, it’ll take 10 years and five months to pay off that $4,000 debt, and you’ll pay nearly $2,275 in interest.
But what if you simply fixed your payment at $160, continuing to pay that amount each month? After all, if you can afford $160 this month, you can probably afford $160 next month.
In our $4,000 balance example, taking that simple step would wipe out the debt in only two years and eight months, and cost $1,051 in interest.
Just fixing your payment on the amount owed this month will reduce the time it takes to become debt-free by 93 months, and it’ll cut the amount of interest paid by more than half! (If you have a balance on one credit card, use this calculator to see how much faster fixing your payments will get you out of debt.)
- Accelerate your payments
To really speed up the process of getting out of debt, add an accelerator amount to the fixed minimum.
Table A shows the impact of adding various amounts to pay off $4,000 of debt. For example, if you add $25 per month ($185 total), you’ll be out of debt in two years and three months. Pay an extra $200 per month and you’ll be out of debt in one year and one month.
If you have multiple debts, you’ll have to decide which debt to add the accelerator amount to. Should you add it to the lowest-balance debt, and once that one is wiped out, roll the full amount into the next lowest-balance debt? Or should you add it to the highest interest-rate debt, and once that one is wiped out, roll the full amount into the next highest interest-rate debt?
It depends. If you want the motivational boost that comes from eliminating one of your debts faster, go after the lowest balance debt first. Completely paying off one debt relatively quickly can provide the motivation to keep going. That approach was deemed best for most people in a study published last fall in the Journal of Marketing Research. Its authors concluded: “Winning what are known as ‘small victories’ by paying off small debts first can give consumers a real boost in eventually paying off all their debts.”
However, from a pure math perspective, going after your highest interest rate debt first will typically get you out of debt a little faster and cost you a little less in interest.
Table B shows an example using four debts — three credit card balances and an auto loan with an $18,000 balance. At the bottom of the table is a comparison between the two approaches — adding an extra $100 to the lowest-balance debt and then rolling the full amount into the next lowest-balance debt vs. adding the $100 to the highest interest-rate debt and then rolling the full amount into the next highest interest-rate debt.
You can see that going after the highest interest-rate debt first gets you completely out of debt one month sooner than going after the lowest balance debt first, and it saves you about $100 in interest. But here is what for many people is the more important difference: By attacking the lowest-balance debt first, you would completely wipe out your first debt in only six months vs. 11 months if you had gone after your highest interest-rate debt first.
Take the time to run some what-if scenarios using information about your debts. (Use this calculator, which will use the order you enter the debts to determine the order in which they will be paid off.) What if you put an extra $25 toward your debts each month? What if you added an extra $100? And try both approaches — the lowest-balance approach and the highest interest-rate approach. The results will help you identify your best approach and motivate you to find extra money in your budget to accelerate your way out of debt.