Debt Management
Accelerating Debt Reduction
In one of my Money Hints and Tips newsletters (Number 13 I think) I refer to a strategy I call Repayment Snowballing. This is used to speed up the process of debt management quicker . There are a few different opinions on how best to implement this strategy so lets have a look at which will save you the most money. There are basically two trains of thought.
Debt Management Strategies
- Pour any surplus cash into paying off your smallest debt first and then when that debt is paid off, adding (snowballing) that repayment onto the next smallest debt until it is paid off or the debt management is achieved. Continue this process, always adding the repayments from the paid-off loans to the next smallest debt until all debts are cleared. (At which time you could give your self a big pat on the back and swear to never put yourself through such agony again!)
- Pour any surplus cash into paying off your highest interest rate debt first and then, when you've achieved debt management for and paid that debt off, adding (snowballing) that repayment onto the next highest interest rate debt until it is paid off. Continue this process, always adding the repayments from the paid-off loans to the next highest interest rate loans until your debt management is complete.
These look very similar don't they! The point in question here is, do you tackle the smallest debt first, or the highest interest rate debt first? In Money Hints and Tips number 13, I simply suggest there could be an argument either way. Psychologically, paying off a small debt quickly can give you a sense of actually achieving something. This can do wonders for your sense of mental well being and provide motivation to go on working at the problem in a positive frame of mind. Mathematically though, it is easy to show that tackling the highest interest rate debt first will always save you money.
Look at this example:-
John and Mary have a Store-Card debt of $10,000 at 21% interest with $200 per month repayments which will repay the debt in about 10 years, leaving them with long term debt management obligations. The total interest will be about $13,800. They also have another debt of $5,000 at 7% interest with repayments of $200 per month which will clear the debt in about 2 years and 3 months. The total interest will be about $900 for this debt. Total interest paid will be about $14,700.
Thinking about the two scenario's above, if John and Mary committed an extra $200 a month to loan repayments they have two options.
If they tackle the highest interest rate loan first, it will be paid out in 2 years and 9 months with a total interest of $3,200. The other loan would have been paid out six months earlier, and if the repayments were snowballed, a further 2 months and $44.00 interest would have been cut from the larger loan. Total interest paid over both loans would be $4056 and total time to repay would be 2 years and 7 months.
If they tackle the lowest balance loan first, it will be paid out in 13 months with total interest of about $200. The other loan will still have 8 years and 11 months to go. If they snowball the repayments, it will be paid off in 2 years and 7 months instead. Total interest paid over both loans would be about $5000 and total time to repay would be 3 years and 8 months, resulting in a shorter overal debt management period with lower interest paid.
John and Mary may have felt great when they paid off the smaller loan in just over one year using the second strategy, but that satisfaction cost them an extra 13 repayments and almost $1000 extra in interest. You be the judge for yourself on this one! Debt management is ultimately a choice.
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