Don’t Save, Pay Off Debt!
There are many debt reduction strategies out there but the idea is that you should be using your extra money to pay off the debt. I know there are people out there who are making the mistake of opening an Emigrant Direct account, putting in extra money, and not paying off more than the minimum payment on a credit card bill. They want to believe they’re getting that 4% interest and the fact that their credit card is only increasing isn’t something that they consider. So let’s do something very simple, let’s figure out where your next dollar should go: savings or bills?
First step is the list all of your debt, its associated rate, and order them in descending order by rate (these are imaginary):
| Best Buy Credit Card | 20.4% |
| MBNA Credit Card | 19.4% |
| 2nd Mortgage | 7.59% |
| Mortgage | 5.25% |
| Car Loans | 4.0% |
| Student Loans | 2.5% |
| Discover Card | 0.00% |
Now list all of your accounts (savings, checking, etc):
| Emigrant Direct Savings | 4.0% |
| 6-mo CD | 3.5% |
| Bank of America Savings | 0.55% |
| Bank of America Checking | 0.1% |
Now order the whole table together, coloring the assets in green and the debts in red.
| Best Buy Credit Card | 20.4% |
| MBNA Credit Card | 19.4% |
| 2nd Mortgage | 7.59% |
| Mortgage | 5.25% |
| Car Loans | 4.0% |
| Emigrant Direct Savings | 4.0% |
| 6-mo CD | 3.5% |
| Student Loans | 2.5% |
| Bank of America Savings | 0.55% |
| Bank of America Checking | 0.1% |
| Discover Card | 0.00% |
If you have any red accounts above a green account and that green account isn’t your emergency savings or otherwise earmarked for something important, you should take all the money from the green account and pay off the highest red account on your list. You should also do this from the bottom up. So in the case above, I’d liquidate the Bank of America Savings account and put it entirely towards the Best Buy Credit Card. (I assume checking is merely for day to day needs and doesn’t hold a sizeable amount)
Why this strategy? Because the debt is growing at a faster rate than the asset, so it would make more sense to put that asset towards slowing down the growth of your debt. Putting money in a savings account while keeping a larger interest debt account is like taking one-step forward and five steps back.
If you want to take it to the next level, you should adjust the rates to reflect what they are after tax benefits (or disadvantages). For example, the mortgage interest rates are actually a little lower because you can deduct them from your income and receive a rebate of some kind. However, that also lowers all your interest-bearing accounts as well because you need to report those at earnings and they will be taxed.
This all seems like common sense but sometimes people just don’t list every account they have and don’t realize they’re saving money at 4% but paying a debt at 20%.
(Listed at OTB’s Beltway Traffic Jam)
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8 Comments - Share Your Thoughts
“Don’t Save, Pay Off Debt!” This is obvious to many of us. If you need an explanation of this, then you’re in debt and don’t really need an explanation because you’re not going to listen to it. You need to evaluate why you are in debt in the first place. What put you in debt. When you realize, comprehend and understand what put you in debt, then you can get out of debt.
Good post!
Sometimes, the most OBVIOUS stuff is not so obvious…
ncnblog.com
Good post, hope to see it in the debt reduction carnival
It won’t be in this upcoming week but I’ll be submitting it for the week after.
I like the “red and green” … nice touch!
The main problem is that people think they’re saving because they have a “savings account” with money in it and don’t even consider that this is actually costing them money (due to paying higher interest on their credit cards, etc).
[...] Like most folks out there, I don’t like owing anyone money. I don’t like owing the bank money on my first mortgage, I didn’t like owing the bank money on my second mortgage, and I don’t like owing the lender money on my student loans. Here is my dilemma… back in September I wrote a relatively straightforward article titled “Don’t Save, Pay Off Debt!” in which I said that you should list the interest rates of your cash and of your debts in descending order. If you happen to have any cash in an account listed lower than a debt, you should pay off the debt with that cash unless it’s earmarked for a specific purpose (down payment, emergency fund). [...]
Ok this is fine but my question is if you are saving for a down payment on a home and you are paying 1% above your savings rate for a car what then? I mean 1% above and a guarantee that you will be out of debt at a certain point. Would you still take your savings and pay off the car?