Episode 4 of the FrugalPod podcast is online and ready for download. You can also subscribe to the podcast via its RSS feed or through iTunes. As always, we encourage you to post your comments, questions, and suggestions for future episodes in the comments section on the blog. Thanks for listening and we hope you enjoy the show.
Episode 4 Show Notes – Talking about methods of paying off debt.
Do you pay off highest interest rate or lowest balance first? Paying off highest interest rate will save you the most money, but paying off the lowest balance may make you feel like you’re getting ahead faster.
Example: You have a credit card with a balance of $5,000 and it has an interest rate of 12% per year. You also have a credit card with a $2,000 balance at 6% interest. The $5,000 credit card costs you about $10 in interest per month for every $1,000 you have on the card and the $2,000 card costs you about $5.00 in interest each month for every $1,000 you owe.
Let’s also assume that your minimum payments are $175 per month for the two cards, but you can pay $200 per month toward your debt. By paying the minimum payment on the high interest rate card and the remainder of the $200 each month on the low balance card until it’s paid off and then pay $200 per month on the high balance card, you will:
- Pay $1,475 in interest
- Pay off the first card in 23 months
- Pay off the high balance card in 44 months
By paying the minimum on the low interest rate card and paying as much as you can on the high interest card, you will:
- Pay $1,303 in interest
- Pay off the first card in 37 months
- Pay off the high balance card in 42 months
The choice you must make is whether you want to have made clear progress by paying one card off in under two years or save $172 in interest.
Should you pay off debt or keep money in the bank?
From a mathematical standpoint, it makes sense to pay off a loan that has a higher interest rate than you’re earning on your savings, but sometimes it makes sense to keep money in the bank.
First, if you accelerate your payments on a 30-year home loan, you may not see the benefits of the extra payments until year 25 or 28. Second, the home is illiquid, so even if you do pay off your home faster, if you need money in the future you will either need to borrow with a credit card or take out another loan against your home. Finally, you may find yourself in a position where you can’t borrow because credit lines have been frozen.
The rule of thumb is to have 6 months of expenses in your savings account. So if you spend $4,000 per month you would need $24,000 in the bank for emergencies. If you’re not there yet, it makes sense to put 70% of extra income into a savings account and 30% into some sort of investment account.
Good debt vs. bad debt
Typically, good debt is borrowing to pay for something that increases in value. Borrowing to go to college or buy a home typically makes sense. Borrowing to buy a reasonable car to get you to and from work is also reasonable.
Borrowing for electronics or clothes is typically not so good. If the asset goes down in value, it’s probably best to buy it without credit. (Yes, the car in the “good” example goes down in value, but if buying the car allows you to get a job so you can make ends meet, it’s a bit of a different story.)
Things to think about when taking on debt
Borrowing for assets that increase in value is considered to be good, but borrowing to buy things that decrease in value isn’t.
Figure out what you can afford. Borrowing $150,000 for college if your career ambitions will only pay you $35,000 per year doesn’t make a lot of sense.
Links to Other Resources
The National Foundation for Credit Counseling is a non-profit organization whose members help people with their credit problems.
{ 1 trackback }
{ 0 comments… add one now }