New research debunks popular method of paying off debt

reply to post by haarvik

I don't understand what you mean by "a rate of $105" that is not an interest rate. Are you talking about minimum payments?

You seem to be talking about cash flow. I'm talking about the most efficient way of reducing debt. Two different things. Want cash flow? Just keep making minimum payments for the rest of your life. You may have money in your pocket but your debt doesn't go down much and you certainly are not saving anything.

Yes, I read the report.

From a normative perspective, debt management is quite simple: To minimize the total amount of debt across loans, people should first pay the minimum payment for each debt (to avoid surcharges and penalties) and then use all available cash to pay down the loan with the highest interest rate.

webuser.bus.umich.edu...
(sounds familiar: www.abovetopsecret.com...)

The trouble is, human nature doesn't seem to encourage proper debt management.

reply to post by Skorpiogurl

I say the interest on the HELOC doesn't matter because if you follow the system you'll never pay more than a few a days worth of interest anyway, and you're paying the loan down much faster than normal.

Incorrect. You will be paying interest on the consolidation amount (less the direct deposit).

Original loan: $20,000.
Living expenses: $3,000
Direct deposit: $4,000
Balance accruing interest: $19,000.

reply to post by Phage


No not talking about cash flow. Payments. Simple math, if you pay more than the minimum, you pay the principal off quicker. The quicker the principal is paid off, the less interest you are paying. By keeping all cards, and focusing on the highest interest rate, you are in debt longer. Getting out of debt takes discipline and it takes time. You don't get into debt overnight, and you are not getting out overnight. There are no "tricks" to getting out of debt. It is simply money management.

reply to post by Maxmars


I think there are multiple factors to consider, here.

For many, their income is very limited, and many people are already living at (or over) their average income. The strategy is simple - drop to your minimum payments on larger loans and pay off the small loans, then roll over into your next largest loan.

For some people, they have to create enough financial slack to even think about paying off larger loans, and you can't do that while still making minimum payments on thousand dollar credit cards or other financed options.

On the whole, though, the strategy is not intended to be a one-size-fits-all solution. Obviously, if you've got a $1000 debt at 3% interest and a $3000 debt at 15% interest - you should target that $3,000 debt before that $1000 - unless you have no other funds to divert to the $3000 payment, in which case, you have to drop something to its minimum and break out of the $1K and roll those payments over into the $3K.

Of course... there's another psychological factor... people have to have the will power to actually roll over their payments and not see an extra $50/month as another line of credit or an impulse buy each month.

But that's with any strategy... it can't work if you don't follow it.

After reading this report, it kinda smells like a bank or credit card funded study.
I would be interested in seeing who funded it.

reply to post by haarvik


Good question... I will see what I can find out on that.... you never know.

i do not see how you would be saving money using this method. being in debt usually means having a limited income to the point where you are struggling to pay the bills.

if you have various debt and you try to pay of the big one first you will only have limited funds to pay extra on it, so you may beable to scrap an extra 10-50 pounds/dollar to pay on the big loan.

however if you pay off all the samller debts first it might take longer before you start paying of the bigger debt but you will beable to throw more cash at it and maybe increase the payments by 150-300 pounds/dollars due to freeing up the rest of your income which was previously being spent on the smaller debts.

it could easily work out that you end up paying of the bigger debt faster because you can throw more at it, rather than paying extra dribs and drabs which take the debt down slowly.

Originally posted by haarvik
reply to post by Phage

 

No not talking about cash flow. Payments. Simple math, if you pay more than the minimum, you pay the principal off quicker. The quicker the principal is paid off, the less interest you are paying. By keeping all cards, and focusing on the highest interest rate, you are in debt longer. Getting out of debt takes discipline and it takes time. You don't get into debt overnight, and you are not getting out overnight. There are no "tricks" to getting out of debt. It is simply money management.

Correct.. no tricks.. but careful planning...

So I pulled my spreadsheet back out (inspired by this thread) and reviewed what my current status is and played with the figures and budget a bit.

I have no shame in my debt so I won't obscure much here.. My current revolving load is $9677.94.

A: 4118.61 @ 22.90%
B: 4438.95 @ 13.24%
C: 1120.38 @ 27.24%

After pulling down the interest (and ignoring that one of those does daily fractional interest instead of monthly) and calculating monthly payments and rollover payments when each line finishes, I tried some differant approaches...

Straight Minimums on all - $6277.86 interest over 106 months

that's not an option..lol

So I upped the payment on each to the nearest $25 and ran it again.. As it turns out, the optimal pay off order was C A B which ended up with $4553.48 in interest over 56 months.

I realized that was about $275/month in payments, so I tried adding another $50/month to C.. that shaved off 8 months and $1376.52 in interest.

So yeah, no tricks, but a little planning and math helps figure out the most optimal approach.


Of course, the first step before any of the math and planning is to stop adding to existing debt. I did that about two years ago.

Originally posted by haarvik
After reading this report, it kinda smells like a bank or credit card funded study.
I would be interested in seeing who funded it.

It was easier than I thought.... the answer is the American Marketing Association.

2011-2012 Board of Directors:

Michael Kullman, Chairperson (DuPont Company)

David Reibstein, Chairperson-Elect (Wharton School of Business)

George Day, Past Chairperson (Wharton School of Business)

Rick Dow, VP Finance/Secretary (Midas Corporation)

Jerome Williams, AMAF Chairperson (Rutgers Business School)

Kathy Button Bell, At-large Board Member (Emerson Electric)

Mary Jo Bitner, At-large Board Member (W.P. Carey School Of Business)

Leona Foster, At-large Board Member (Market Strategies International)

Gerri Henderson, At-large Board Member (Rutgers Business School)

Jeff Hunter, At-large Board Member (General Mills Inc)

Michele Kessler, At-large Board Member (Univision Communications Inc)

Gary Lilien, At-large Board Member (The Smeal College of Business Administration)

Rob Malcolm, At-large Board Member (Consultant/Wharton School of Business)

Russ Winer, At-large Board Member (Stern School of Business)

Dennis Dunlap, Ex-officio Board Member (AMA)

There are some heavy hitters in the group.... but raw financial sector membership seems minimal.... not that it means anything considering the way our "transnational" corporations all interbreed.

To be really savvy, you should pay off the lowest interest rates first. As soon as you do, they inevitably send you those balance transfer checks, because they don't want your account sitting there empty. So, the following month you use the checks to transfer as much of the high interest debt as possible. Usually you can get 12 to 18 months at no interest, or very low interest for transfers.

My brother just got finished negotiating all of his credit card debts down for about 25 cents on the dollar. $10,000 became $2,500, and $3000 became $1100, etc. They wiped out all his interest, he sent them some decent sized payments initially, and now they are on agreeements to be repaid within 12 months. Saved him from having to file bankruptcy, and he didn't have to use any of the attorneys or credit counseling places.

reply to post by rogerstigers


I'll be honest with you, this doesn't really affect me much since my cost of living expenses are higher than my income (comes with the turf, not whining.) But in the days when i used to be credit dependent, I might have benefited greatly from the input you all have shared here.....

Eventually, I must reestablish my "credit presence" in the financial world.... it's the "mark" you can't really do business without.... so this discussion is relevant to me; or anyone within striking distance of freeing themselves from debt.

Just some simple touchy-feely math says to pay off in the manner consistent with reducing total interest charges the most, leaving more money to pay off other accounts and/or pay with money you have first.

reply to post by rogerstigers

So I upped the payment on each to the nearest $25 and ran it again.. As it turns out, the optimal pay off order was C A B which ended up with $4553.48 in interest over 56 months.

Exactly, pay off the highest interest loans first in order to minimize total interest expense. It really works. The size of each debt is irrelevant. It is the interest rate you pay on each that is important.

reply to post by getreadyalready

Credit surfing works great. I used it back in the day myself.
No need now, fortunately.

New research?

What happened to basic common sense and logic. If $200,000 is costing 7% interest and something of $4000 is costing you 5%, which do you clear first?



Gee, no wonder the world is messed up!

Originally posted by daggyz
New research?

What happened to basic common sense and logic. If $200,000 is costing 7% interest and something of $4000 is costing you 5%, which do you clear first?



Gee, no wonder the world is messed up!

In that case, the $4000 would go first, depending on minimum payments and all that. basic rule of thumb for me is if the lower cost loan would be finished before the higher cost loan anyway, it's probably ok to pay it off and roll over the payments.

reply to post by daggyz

The study was not about finding the best method of debt reduction. It was about why people have trouble managing their debt. The conclusion, people tend to pay off their debt in a way that makes them feel better about it rather than the most efficient way.

In this research, we provided consistent evidence of debt account aversion. In three field surveys and four experiments, consumers faced with multiple debts prioritized reducing the number of debt accounts over reducing the total amount of debt across accounts. That is, rather than repaying the debts with the highest interest rates more quickly (the financially optimal strategy), many consumers chose to repay the smallest debts as soon as possible.

webuser.bus.umich.edu...

this is going to differ for different people. i suppose the study is right in some cases, but is sending the wrong message in other cases.

it all depends how much disposible income people have in the first place. some people can only pay the minimal payments and inorder to beable to pay more than the minimal they have to free up other income inorder to be in a postion to increase the payments on the larger loan. in this case it would make more sense to pay off some smaller debts first.

but if you have money to play with from the start that you can put into other bills without the need of freeing up more money, then it would make more sense to pay which ever bill is creating more money in interest.
whilst it is still a debt, i would not consider the person to be in debt in the first place if this was the case as their income is still greater than their out goings. and therefore can afford the loan payments with extra cash left over.

the top scenario if far more common than the second one in the current climate, and i feel it is dangerous to say there is a correct way of doing it and a wrong way of doing it. both ways work if used in the correct situations, if they are used in the wrong situation then they can do more harm than good, because it will always depend on the disposible income of the person in debt as to which method is best.

reply to post by Maxmars


Um, of course. Although, it's nice to see a study confirming what I have always believed. Still fighting my way out of debt, and plan to never be there again.

Originally posted by haarvik
I don't subscribe to this. My wife and I did ours like this:

Paid off a small one first, then took that payment and added it to the next one. When that one was paid off, we rolled those two payments to the next one. It's all the same money going out, but it snowballs and before you know it you are paying down some serious debt. In addition, as you pay these off, your credit score goes up. It's simple, and it works. Anyone advocating otherwise is doing nothing but encouraging you to stay in debt longer.

This is a good concept, but it works with the larger debts as well, I started by paying on one large debt and a few smaller ones. As a smaller one would get paid off, I would apply 1/2 that payment to the larger debt and the other half to one of the smaller debts. Then when that smaller debt got paid off, I would do so again. On the 3rd iteration, I started to pay a 2nd larger debt. Continueing to do this has gotten all of my smaller debts paid off, and I only have two larger debts left.

When I went to a credit counselor, they said it would take 10 years to pay off my debts, I will be paid off in less than 4 with my method, about another 16 months.