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I have been researching this topic quite extensively, because I would like to know what would be the mathematically correct way to best pay off debt to avoid paying the most interest over the long run. Currently, I have two student loans, as follows:
$10,000 @ 5.5% @ 17 years remaining
$6,000 @ 6.8% @ 7 years remaining
Which loan should be paid off first, so that I am left with having paid the least interest expense in the long run?
According to financial experts, two methods are offered. First, the Debt Snowball method, which advocates paying off the debt with the lowest balance first. I can see the benefit to this, in that the sooner this debt is paid off, the sooner you can start saving more money to apply toward the next debt. But, I don't believe that this is necessarily going to leave you with more cash in your bank in the long run.
The second method is the Highest Interest Rate method. This is where the loan with the highest interest rate should be paid off first. However, this is only true if the principal and/or remaining time on the loan are about equal.
Now, I spent much time thinking over this issue, and came to the conclusion that both of these methods are flawed. I actually believe that the best way to pay off debt would be to first pay off the loan that has the shortest remaining term. The period to pay off debt is essentially a long term deadline that you have. Why not pay off the loan with the shortest term first? Like this you have a much bigger shot at preventing yourself from making continuous interest payments, regardless of the interest rate. Then, once this loan is paid off, tackle the next loan that's due, and once again, attempt to pay it off early and prevent yourself from paying more interest over the years?
In my situation, I would choose to pay off the second loan first, because it is only a 7-year term versus 17 years with the first loan. Like this, the sooner I pay it off, I can have it paid off several years early, for sure. Then, target the 17-year loan, and I will most likely have it paid off in half the term allowed for payoff.
Does my Shortest Term method make financial sense? I understand that given my two loans, it's a no brainer that the second one should be paid off first, because it is the highest interest rate and the shortest term. But, I am interested in hearing what others have to say.
I agree. Then, when you've paid off the one, apply the payments you now don't have and pay off the 2nd early. You've already lived without that money and even tho it is a pain, you'll be amazed at how fast you can get it paid off.
It reminds me of the girl a few cubes over. She has decided that she needs to lost 40 pounds this year. For the past month, she has been evaluating which diet plan to go on as to which will be quicker, which is easier and the like.
The only method that really makes sense is to tackle the highest interest rate first.
For the scenario you presented, all 3 methods you pose lead to the same conclusion:
Highest Interest: 6.8% (Choose this if you want to pay the least interest pay off all loans fastest)
Lowest Balance: $6,000 (If you need an emotional "win")
Shortest Duration: 7 years (If you want to experiment with your new method)
Like others have said, the most important thing to do is to start paying.
The only method that really makes sense is to tackle the highest interest rate first.
For the scenario you presented, all 3 methods you pose lead to the same conclusion:
Highest Interest: 6.8% (Choose this if you want to pay the least interest pay off all loans fastest)
Lowest Balance: $6,000 (If you need an emotional "win")
Shortest Duration: 7 years (If you want to experiment with your new method)
Like others have said, the most important thing to do is to start paying.
This is what I was thinking. I got into debt after college and started snowball payments of my highest interest card. Once I paid off my car the cards were down in 3 years.
The snowball method works best when you have several loans with small balances, not as well when you have two medium sized loans.
As for the "shortest term vs longer term", if the loan charges interest depending on the current principal balance, like house loans, car loans, or student loans and credit card loans (in other words, most loans), you are better off making extra payments as early in the process as you can.
For example, on a 30 year $100k mortgage, paying $100 extra a month in year 1 would take almost a year off the loan and save you about $5000 in interest. However, paying $100 extra a month in year 30 takes about a month and a half off and saves you about $30.
Therefore, the longer loan is the better one to make the payment on, all other things being equal.
In your case, however, with the smaller loan also being the higher interest rate, I would pay that one off first.
Dave Ramsey says to always pay the smaller debts off first and work your way up to the bigger ones.
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