How to pay off debts
Don’t have any debts is a great feeling, but not only that. If you have debts you are constantly paying interest for the money you owe. I bet you already knew that. But how this interest influences your debts over time probably not. So if you have debts or just want to know why you should never build then, this article is perfect for you. Therefore I will tell you in this article why you have to pay off your debts if. I will show you how you can save up enough money for paying off your debts. And I will give you two exact methods on your hand for two different kinds of people to pay your debts off as efficiently as possible.
Pay your debts off first
Having debts is extremely dangerous if you don’t pay them off.
In America, more than 57% have a credit. On average, a credit cardholder has four different credit cards.
But the most shocking thing is that the average household with a credit card carries more than $8000 off debts. Most of these people would easily be able to pay their debts off.
But who likes it so open the new post that comes from your bank and telling you bad news again? So most people are probably just ignoring those letters and their debts for years. What happens if you do this can you see in this graph:
As you can see the interest you have to pay (10%) over time adds up fairly quickly. And this graph only shows you the overall interest if you pay it directly. If you don’t pay it directly you would have to pay so much more because of the compound interest.
But you don’t only have to pay this interest, you are also missing out on the opportunity to invest this money. So if you wouldn’t have any debts and therefore invest the whole money your money, at 6% interest, would have grown like this:
As you can see if you would have invested the money rather than use it to pay your interest. Because you would have gained the amount of money or this time. This brings up your cost of having debts to the amount that you had to pay in interest plus the money you had if invested the whole amount. In our example number.
But not all debts you have are bad, and not all debts have to be paid off as quickly as possible. Know you may wonder which debts could be good? And I am going to tell you. Debts are good if they make you money. This happens if like now the key interest rate is extremely low and therefore you can borrow the money from your bank and invest it, for example, in a renting property. The effect can be described as getting a cheap loan and earn more money then the interest that has to be paid trough the investment itself.
These mostly long term debts shouldn’t be paid immediately. As well as other longterm debts you might have your house, for example. This is because the interest you have to pay for those is in comparison shallow. The debts you should pay off are these short term debts with high-interest rates. For example, debts from your credit card. Because you may pay more than 10% interest for those.
To pay debts of is investing
You saw the numbers about and there shocking, but another reason why you should pay off your debts is that you get an extremely high fixed yield on the money you use to pay off your debt. This is because you save the money you have to pay in interest if you pay off your debts. Completely clear, but you can think of this saved as your yield for the money you used to pay your debts. This may sound a bit strange to you but think about it again.
Maybe it becomes more clear if you think that you invested your money in stocks. And that investment brings you enough yield to cover the cost that comes from your debts. I hope you got my point now. If you do so it should be clear for you that you can earn more than 10% as interest on your money if you pay off your debts. In times where the key interest rate is around zero. While you normally would get an average of around 7% with a risk if you buy stocks. And that is the next point, this probably over 10% yield is guaranteed and you don’t have any risk of getting this yield, just crazy.
If you have debts I am pretty sure by now that you understand why you should pay them off. But if you still think „It doesn’t matter.“ or you are like „Why is 10% yield so much?“ you should know the magic of compound interest. Albert Einstein once said, “Compound interest is the 8th wonder of the world.“ and if you don’t know why he said that, you definitely should read this blog article:
How to pay off your debts
Before I give to methods on the hand I first have to tell you something else. How you can get the money to pay off your debts. That you need the money to pay off your debts is extremely clear, but how to get it not. In reality, you don’t really need to get it, because you already have it. What you must do is save it to use it for this.
To do that you just have to do one thing, budget your money. The exact guide on why to do this and how to do this is here:
Know that you have more money left over you can start to pay off your debts after you decide which method you want to use. There are two different methods for two different kinds of people. If you are more the rational type and disciplined type, you should go with the Avalance method. This method is more efficient than the other. But you really have to stick to your goal. Otherwise, it is not right, and you should go with the snowball method. This method is excellent in terms of keeping you motivated and give you fast wins. I would suggest that you read trough booth methods first, and then decide which one is the best for you.
First Method: Snowball Method
This method suggests that you always pay the smallest debt off first and stick to this pattern until all your debts are paid off.
So the needed steps are:
- Sort your debts from the smallest all the way up to your highest debt.
- Only pay the minimum amount on all your debts, and as much as you can on your smallest.
- Repeat the second step until all your debts are paid off. Pretty easy, right?
This will get you really fast smaller wins because you should have paid off your first debt really quickly. It will keep you motivated, especially at the start. You get small debts easily out of your mind and have to pay less interest if you pay off your bigger debts. There fore these will be out of your way faster. But it is not most efficient, because you may keep debts with higher interest rates longer then debts with lower interest. This leads us to the next method.
Second method: Avalance Method
This method fixes the problem that the other has by taking away the advantages. It does this by suggests to pay the debt with the highest interest first. Therefore you can reduce the overall interest you have to pay. If you want to follow it you have to:
- Sort your debts by the interest rate. This can be complicated because you have to check the contract first in order to make sure that you have done this right.
- Only pay the minimum amount on all your debts, and as much as you can on the debt with the highest interest rate.
- Repeat the second step until all your debts are paid off.
This will technically save you time and money. Because you pay less interest overall and therefore need less time to pay all your debts. But this effect won’t bring you any benefit if you are not patient enough to stick to it. It clearly is harder to wait longer for the results. If you really need these motivation kicks that you get from the snowball method you should use it. Because of the fact that you could end up quitting this whole thing and then the few extra dollars you could have saved arent relevant overall.
This comparison I am going to show you is only based on numbers. But you have to consider more when deciding which method to use. So read the whole article to the end, because there are actual studies that show which methods work best in real life.
If we have this loan structure:
If you pay all the minimum Payments in the example you would have to pay amount $270. Just assume that you would pay another $230 in the loan that you focus on.
The Snowball Method
With this method, you would have paid all your debts back in 75 months. The first debts would be paid completely after 14 months. And the total amount of interest you would have paid is $10.583. This already sounds pretty good, but how would it with the other Method?
The Avalance Method
Here you can see that it would have taken you 32 months to pay your first debt off. But it also gets clear that you would have paid only $8.437 in interest over a period of 72 months. That means this method would have saved you $2.146 and 5 months overall.
If you want to know how big the difference is in your scenario you can download the spreadsheet here and calculate it again with the exact numbers of your situation.
Which Method is the best?
Mathematically the Avalanche method is clearly the better choice. But we all are humans and no roboteers. Therefore for most people would be the snowball method the better choice. The first study I wanted to show you from Kellogg School researchers reveals that:
„People with large credit-card balances are more likely to pay down their entire debt if they focus first on paying off the cards with the smallest balances — even if that approach doesn’t make the best economic sense.“
The second study I read has the result that:
„Pay the smallest debt first“ is a straightforward strategy that can be easily communicated and easily applied—and that’s sorely needed by millions of American credit card users.“
I personally found these results mind-blowing.
I wouldn’t have gone for the snowball methods approach because the avalanche methods make so much more sense to me. But as soon it took into consideration that there are people who can’t stick to the strategy and the quit there whole „paying off debts“ goal it made total sense to me. Consequently, I would only advise you to go with the avalanche method if the difference between boot methods is really huge in your personal situation. Or you are more than 100% sure that you can stick to the avalanche method until the end. Tell me what you think in the comments.
Thanks for reading!
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