What Is The Best Way To get Out Of Debt: A few days ago, I was having a conversation with a coworker about money. We happened upon the subject of how many more hours he had been working in the last few weeks. Recently, he decided to pick up extra time at his current job and then go to a side-job after work for about 2-3 hours per day. He is doing this 4-5 days per week! I was amazed by his intense work ethic but learning about this situation left me with a few questions..
“Why are you working so much?” I asked.
“Well, I have a grandson on the way which I want to have some money saved up for but really I’m trying to get ahead financially” He responds.
We discuss his goals some more and it turns out he’s trying to decide how to best use his money to get ahead. When we were talking, he referenced a few debts but only in general terms. For the sake of this blog post, we will say the financial story is something like this:
- Credit card debt of $20k at a 16% interest rate with a minimum payment of $200 per month
- Student loans of 40k at a 7% interest rate with an assumed payment of $464.43 per month
- Car loan of 30k at a 6.5% interest rate with an assumed payment of $587 per month
From what I was told, the payment for the car loans is much higher than the student loans so I assumed the respective payments above.
Navigating debt can sometimes feel like walking a spiky tightrope.
Where do you even start?
Let’s break down these debts in more detail. First, let’s start off with the credit card debt:
Credit card debt:
That calculation is run based on $20,000 in credit card debt at 16%. After some research, the average minimum payment is 1% of the balance. If my friend pays the hypothetical minimum payment, he will effectively never get out of debt! How crazy is that?
The scarier part about all of this is that the $20,000 in original debt will end up costing him $206,849.89 after 30 years!!! That is a truly frightening number. This is an example of compound interest gone wrong!
Student loan debt:
After putting all of this information in a student loan calculator, here is what we have:
So just in a quick run through we see that every month, this debt costs my friend $464.43. The worst part is that is what it will cost him for over 10 years. The total interest paid in $15.732.07, which is just more money that is getting fleeced from him.
The car loan
I’m going to start with this – my friend drives a very nice car. It’s a high end luxury sedan with all the features you could want. Now, everyone is allowed to drive what they want, provided they can afford it. But for the sake of this article, let’s see how much this car is setting him back.
From the information I have, this is where we stand in terms of the car payment:
Although it’s a great car, is it worth $587 per month? That’s debatable. Thankfully, the total interest charged on this debt is only $5,219, which is not nearly as bad as the student loans or the credit cards.
Let’s take a look how much my friend pays per month on this debt.
Charges per month:
Car payment: $587.00
Student loans: $464.43
Credit card: $200.00
Overall, not terrible and definitely manageable. But of course, that’s what any lending organization wants you to think. If the payments are manageable, you’ll just put up with them and they can charge you interest. So, let’s take a look at the interest my friend is charged on this debt:
Total interest charged if the full loan term is completed:
Car payment: $5,219
Student loans: $15,732.07
Credit cards: $206,849.89
Although the credit card has the lowest payment of the group, it’s tricky because it also has the highest interest rate (16%) which is where credit cards really start to get you. As we said before, this $20k in credit card debt will end up costing him 10x that ($200k) and he will never get out of unless he does something drastic.
What should you do first?
Let’s talk strategy for a second here. There are two primary strategies in the area of debt repayment, the debt avalanche and the debt snowball.
As per Investopia, the debt avalanche is:
“A debt avalanche is a type of accelerated debt payoff plan. Specifically, a debtor allocates enough money to make the minimum payment on each debt, then devotes any remaining debt-repayment funds to the debt with the highest interest rate. Using the debt avalanche method, once the debt with the highest interest rate is entirely paid off, the extra repayment funds go toward the next highest interest-bearing loan. This method continues until all the debts are paid off.”
The debt snowball is:
“Debt snowball is a method of debt repayment in which the debtor lists each of his/her debts from smallest to largest (not including the mortgage), then devotes extra money each month to paying off the smallest debt first while making only minimum monthly payments on all the other debts.
Once the smallest debt is paid off, the debtor starts putting extra money each month toward paying off the second-smallest debt while continuing to make only minimum monthly payments on all other debts. The debtor continues this process, paying off each debt from smallest to largest, until all the debts are paid in full. The debt snowball method is advocated by Dave Ramsey, the host of a popular call-in personal finance advice radio show and bestselling author of several books and programs on getting out of debt.”
Which one is more effective?
Well, in my opinion that depends on your personality. What are you motivated by? Quick wins or knowing you’re doing the most effective approach?
Personally, I’m all about being as effective as possible so for this article we are going with the debt avalanche because that crazy interest rate of 16% needs to go!
Getting things done
There are a few approaches my friend could take to help with this debt. Granted, he is working more to give himself extra money to get ahead. So where should he put the money? Towards the highest interest debt. Even if it seems imposing, paying off the high interest debt is the best use of his money because it will reduce the amount that he is charged over time.
Even if he doesn’t have $20k to pay everything that’s fine. Break it up into $500 or $1,000 units and chip away at the debt when your budget allows.
With the high interest debt out of the way, he can begin moving towards the next most logical target – student loans. Why student loans? Even though the payment is less than his car payment, student loans stick with you forever. Even with a bankruptcy, they will be there. So, in order to be closer to debt freedom, you need to get rid of these loans.
If you would like to see my own story with student loans, check out the post here.
A more extreme option involves getting rid of the car for something with a smaller or non-existent car payment. That would give him an additional $587 per month to throw at his credit card debt/student loan debt, which further accelerates this whole process.
After these debts are paid, our friend will have an additional $1,251.43 to save or invest but more importantly, he will have saved himself $227,800.96 in interest by paying these loans early. The monthly payment is nothing compared to saving the equivalent of a medium priced home in terms of interest.
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