Help With Debt – Which Loan do I Pay First – Evan answered

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Debt repayment advice for Evan

Evan asked:

What is your input on my debt repayment stuff I have posted here:  Goals and Objectives for 2010 – Help me Out!

Here is the gist of Evan’s sitch:

Current debts:

  • $12,000ish Auto Loan 8% – 7 year amortization schedule
  • $7,000 Law School Loan #1 – 5% 10 year amortization schedule
  • $57,800 Law School Loan #2 – 4.5%, but payments are increasingly tiered costs over 30 year amortization schedule
  • Mortgage of $228,000ish – 5.875% – 40 year amortization schedule

Nothing here screams at me get rid of it.  So the first question I have to decide is which one I am going to focus on? Here are my issues with each one:

  • It feels weird prepaying the Auto Loan since it is a depreciating asset.  It is very unlikely that I will own the car until it dies.
  • Law School Loan #1 is capped at 5%, and may be tax deductible
  • Law School Loan #2 is capped even lower at 4.5% and again may be tax deductible.
  • Mortgage doesn’t seem worthwhile since The Wife and I have plans to be out of here within the next couple years.

I think I am going to start paying down Law School Loan #1, but I want to hear alternating theories PLEASE TELL ME IF I AM WRONG. (I have since learned from Evan that he has changed his mind and is going to begin paying the auto loan off first.)

The next question comes down to How am I going to Pre-Pay the debt? I think I am going to prepare a whole bunch of $25 Checks marked “For Principal Only” and then send them weekly or bi-weekly depending how aggressive I am feeling that week.  Why $25? Because my checking account is unlikely to feel just $25.  Any and all income I receive from my blog will also be applied to that debt.

Debt reduction order and strategy

Luckily we’re not going into this blindly, as there are several popular debt repayment strategies we can draw upon for advice, then tailor our solution to Evan’s situation.  Today we will focus on the two best strategies:

  1. Debt Snowball – Dave Ramsey, the mouthpiece for this method although I’m not sure if he should actually be credited with its creation, advises thousands to order their debt repayment in order of debt account balances, regardless of account interest rates.
  2. Debt Avalanche – Flexo of Consumerism Commentary analyzed the math and came up with this strategy that is based on paying your highest interest (after tax) debt first, regardless of account balances.

Here is what I would do Evan:

I will answer both questions by suggesting a single strategic solution.

Although I am a big fan of both Dave and Flexo, in regard to a debt reduction strategy I have to side with Flexo on this one… not because I like him better (I dig both trailblazers), but because his math is better.

My advice to you is simple:

  1. Establish an emergency fund. You don’t mention the existence of an emergency fund, but do mention a trading account.  I advise you to close the trading account choosing instead to move the $2,000 into an high yield savings account for use as an emergency fund.
  2. Order your debts from highest interest rate (after tax) to lowest. Do this regardless of debt amounts.
  3. On the highest rate debt commit all available cash. Now that you have established an emergency fund in step one you can comfortably commit all extra cash to your highest rate debt.  That means the auto loan is the winner – as the answer to your first question.
  4. Make minimum payments on all debts except the highest rate debt. This will keep all other debt accounts current while you focus the bulk of your available funds to the debt that is costing you the most.  And committing all available funds to this debt is the answer to your second question.
  5. Wash, rinse, repeat. Follow this strategy all the way to debt freedom by simply replacing each paid off debt with the next highest rate debt until you are no longer in debt!

Many will argue in favor of Dave’s debt snowball plan, but as Flexo points out… they can never give accurate mathematical proof to support their claim.  Understand that I am not bashing Dave’s plan, if you or anyone else needs the emotional wins of paying off small debts first, then by all means they should employ the debt snowball.  But if you want to pay off debt as fast as possible while paying as little interest as possible, then follow Flexo’s debt avalanche method.

The Debt Avalanche will make your how much debt costs spreadsheet graph turn in your favor faster than anything else!

Above all things, always remember… “You can’t go wrong getting out of debt!”  – Dave Ramsey

What do you think?

Did I miss any glaringly obvious advice for Evan?  What would you do if you were in his situation?

If you need debt help or personal finance advice – Ask Matt Jabs.

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