Many people have multiple sources of debt from mortgages, student loans, auto loans to credit card debt. Deciding which debts to focus on paying off first can save you a huge amount of money in the long run or cost your a huge amount if done incorrectly.
The general rule of thumb for paying off debt is to always pay of the debt with the highest interest rate first. Doing this will ensure that you minimize the total interest paid in the long run. Many people do not think about interest rates when paying off debt and this could cost them large amounts of money!
For example let's say Bill has the following debt listed below: (The example is kept simple to illustrate the point)
Mortgage: $100,000 at 5%
Credit Card: $100,000 at 15%
Let's say Bill decides he wants to pay his home off early and starts paying an additional $10,000 per year toward that loan. In the first year Bill pays the additional $10,000 on January 1st. He now has $90,000 outstanding on the mortgage and $100,000 outstanding on his credit card.
For simplicity let's assume that these loans are interest only loans. In this scenario Bill will pay $4,500 (90,000.05) in interest on the mortgage and $15,000 (100,000.15) in interest on the credit card if no additional payments are made in year one. Total interest expense for year one will equal $19,500 if this strategy is used.
Let's say Bill is smart and decides to pay the high interest credit card loan instead. If the $10,000 in additional payments are made toward the credit card loan instead he will pay $18,500 in year one instead of $19,500. Paying off the credit card loan will save Bill the spread of 10% multiplied the $10,000 of additional payments made in year one which is $1,500.
This savings doesn't stop in year one as each year Bill pays the higher interest rate loan down he saves more and more money. Over the long run the savings would be huge.
The main point of this article is to make people aware that analyzing the interest rates when paying off debt is important and could save you significant amounts of money in the long term if done correctly.
If you are not sure how to manage your debt payments you should discuss it with a financial advisor who will be able to put together a payment plan that will minimize the interest that you will pay.
This article is for informational purposes only and should not be considered legal, financial, investment or accounting advice. Please consult your own advisor before making any decisions.