Many people today are feeling the pain of debt and are desperate to find ways to reduce their debt load. The pain will likely get worse in the near future – as the economy recovers we can expect the Fed to raise interest rates sharply in light of expected inflation due to our massive government debt.This will raise the minimum payments on home equity lines of credit (HELOC’s) which are typically tied to the prime rate, which reached 8.25% in 2007, compared to today’s 5.15% (Bankrate.com).As interest rates go up, consumer budgets will get squeezed even further than they already are. To avoid the most pain in the long run, what's the best debt reduction strategy?
Options for paying off debt
Which loan should you payoff first if you can afford to pay a little extra each month, or if you get a windfall from an inheritance? Some of the more common debt-reduction strategies used by consumers are:
Payoff the shortest remaining loan term. There’s great satisfaction in paying off a loan so it makes sense someone would choose to do this. However, paying off the shortest loan isn’t always the least expensive path.
Payoff the highest balance first. It’s easy to understand why this is attractive – when you reduce the amount you owe on the loan, it benefits you every month until it’s paid off. And paying off your home is one of the most liberating feelings.
Payoff the lowest balance first. The reasoning here is that you will put the biggest dent into the loan with the smallest balance. It may sound like the best approach, but isn’t necessarily so.
Payoff the lowest interest loan first. The idea here is the more you pay on a lowest interest rate loan, the quicker it will be paid.
So what is the best approach?Let’s look at an example.John has three loans as follows:
- An auto loan at 6.50% fixed with 30 months and $25,000 remaining on a 48-month $30,000 loan.
- A mortgage at 5.75% fixed with 20 years and $332,481 remaining on a 30-year $400,000 loan.
- A home equity line of credit at 5.50% fixed with a $23,000 balance.
So what’s the quickest way to pay down debt?
John has decided he wants to cut $500 per month in expenses and use that money toward paying down his loans faster.From a financial perspective, the strategy which costs the least amount of interest until all loans are paid off is the best strategy.Here’s what each of the above strategies cost John:
Payoff the shortest loan term first (the car) : $158,358
Payoff the highest balance first (the house): $155,732
Payoff the lowest balance first (the HELOC): $158,863
Payoff the lowest interest loan first: $158,863
Actually, the best option is to payoff the loans with the highest interest rate first.If John follows this strategy, he would pay only $155,539 in interest.In general, paying off the loan with the highest interest rate first will always be the cheapest and quickest way to eliminate debt.The wrinkle comes in when some of the loans have variable rate interest.Most people with a HELOC have a variable rate interest tied to the prime rate.Although most HELOC rates are very low today, they could rise quickly to very high levels, so knowing which is the highest interest rate loan in the future may be difficult. In this case, give us a call so we can give you some guidance.