Paying off debt. There are already hundreds, if not thousands of articles written about this subject. I'm not here to rehash the same thing that every other finance blog has already written about. If you Google "debt repayment methods" you'll find a trove of information on the subject.
I'm here to talk about the method I used to pay off $40,000 of debt in 9 months.
Okay, but first I do need to rehash just a tiny bit about debt payoff. I promise I'll be very brief.
The 2 Common Repayment Plans
The Debt Snowball Method
The Debt Snowball Method (coined by Dave Ramsey, I believe), tackles the smallest amount of debt first, while paying minimum monthly payments on all other debts. After the smallest has been paid in full, you move on to the next smallest, and so forth until all debt is repaid. While this isn't the most efficient way to tackle debt, it can provide quick victories up front that some people argue is better for your mentality.
The Debt Avalanche Method
The Debt Avalanche Method tackles the debt with the highest interest rate first, while paying minimum monthly payments on all other debts. This method is more efficient because it tackles higher interest rates first. However, if a high interest rate loan is a large debt, it can take a while to pay off. This can lead to you feeling like you aren't moving the needle (even though you are).
Yes, we are done rehashing.
Those are the two common methods of debt repayment that the FI community frequently discusses. Again, if you aren't familiar with these and want to learn more: click here.
Okay, back to the point of this post. I want to share with you a variation on the Debt Avalanche Method. It's what I like to call:
The Advanced Debt Avalanche Method
Great name, right? Maybe I'll come up with something better down the road.
When I was paying off my student debt, I decided to use the Debt Avalanche Method because I wanted to be out of debt as quickly as possible. But I quickly realized that the Debt Avalanche Method wasn't actually the most efficient way to pay off debt.
Let's look at an example. Let's pretend our good friend Fred has the following loans:
$1,000 with 10% interest
$5,000 with 3% interest
$7,000 with 6% interest
$12,000 with 2.5% interest
According to the Debt Avalanche Method, Fred would pay off the $1,000 loan first, because it has the highest interest rate. But if we do some quick calculations, you'll see that it isn't the loan that is acquiring the most interest.
Important Note: For simplicity, I am ignoring minimum monthly payments. In real scenarios, minimum monthly payments would be made, reducing the amount of each loan every month.
First, let's use this formula to find out the daily interest accruing for each loan:
Loan Amount x Interest Rate / 365 = Daily Interest
Loan A: $1,000 x 0.10 / 365 = $0.27
Loan B: $5,000 x 0.03 / 365 = $0.41
Loan C: $7,000 x 0.06 / 365 = $1.51
Loan D: $12,000 x 0.025 / 365 = $0.82
Using this formula, it is easy to see that the $7,000 loan should be attacked first, as it is accruing $1.51 each day, while the highest interest rate is only accruing $0.27 daily. Just because a loan has the highest interest rate, doesn't mean it is accruing the most interest.
Yeah, that's right Fred. Mind blown.
Fred should start by paying down the $7,000 loan with any extra income he brings in. But should he pay off the loan in full? No, he shouldn't! If we reverse the equation, we can find at what point the daily interest accrual of Loan C matches the next highest, Loan D (the $0.82 from the $12,000 loan):
Target Daily Interest x 365 / Interest Rate = Loan Amount
Loan C: $0.82 x 365 / 0.06 = $4,988.33
In this case, Fred would want to pay down his $7,000 loan (Loan C) to $4,988.33. At this point, Loan C and Loan D (the $12,000 loan) are accruing the same amount of interest daily. Fred can split his extra income towards both of these simultaneously, prorating the amount he puts towards each (we'll find these exact percentages in a moment). But first, let's use the second formula again to figure out at which point Loan B (the $5,000 loan) takes over accruing the highest daily interest of $0.41:
Loan D: $0.41 x 365 / 0.025 = $5,986
Loan C: $0.41 x 365 / 0.06 = $2,494.17
So Fred should work to get Loan D (the $12,000 loan) down to $5,986 (target amount) and the Loan C (the $7,000 loan, now at $4,988) to $2,494 (target amount) simultaneously. Once he does this, these two loans and the $5,000 loan are all accruing the same daily interest of $0.41. And now that we know these numbers, we can also figure out what percentage of extra payments should go towards Loans C & D by following these steps:
Find the difference between the current loan amounts and their target amounts.
Add the differences together
Divide the differences found in Step 1 by the sum found in step 2. This will give you the percentage of extra income that should go towards that loan.
Let's do this together.
Step 1
Loan D: $12,000 - $5,986 = $6,014
Loan C: $4,988 - $2,494 = $2,494
Step 2
$6,014 + $2,494 = $8,508
Step 3
Loan D: $6,014 / $8,508 = 0.71
Loan C: $2,494 / $8,508 = 0.29
Now we know what percentage of extra income should go towards each loan for extra payments. 71% should go towards Loan D and 29% should go towards Loan C. So if Fred has an extra $100 after making his minimum required payments towards each loan, he should put $71 towards Loan D and $29 towards Loan C. He should continue splitting his payments this way until they reach their respective target amounts found using our second formula ($5,986 for Loan D and $2,494 for Loan C).
Once Loans C & D have hit their target amounts (matching Loan B's daily interest accrual of $0.41), Fred can once again use the second formula to figure out new target amounts, at which point he should also put extra payment towards the $1,000 loan (Loan A), because all four loans will each be accruing $0.27 daily:
Loan D: $0.27 x 365 / 0.025 = $3,942
Loan C: $0.27 x 365 / 0.06 = $1,642.50
Loan B: $0.27 x 365 / 0.03 = $3,285
Again, we can use the steps above to figure out how his extra payments should be split between these three loans.
Step 1
Loan D: $5,986 - $3,942 = $2,044
Loan C: $2,494 - $1,642.50 = $851.50
Loan B: $5,000 - $3,285 = $1,715
Step 2
$2,044 + $851.50 + $1,715 = $4,610.50
Step 3
Loan D: $2,044 / $4,610.50 = 0.44
Loan C: $851.50 / $4,610.50 = 0.19
Loan B: $1,715 / $4,610.50 = 0.37
Fred should put 44% of extra payments towards Load D, 19% towards Loan C, and 37% towards Loan B, until they reach their new target amounts ($3,942, $1,642.50, and $3,285, respectively).
Once Fred has brought these three loans down to their respective target amounts, all four of his loans will be accruing $0.27 daily and he can split his extra payments between all four loans. Once more, we can use the steps above to figure out how his extra payments should be split. Because this is the final loan, Fred's target amount for each loan is $0.00. This means we can skip step 1 (because the current loan amount minus zero is still the current loan amount). Instead, we can just add all of the current loan amounts together:
Step 2
$3,942 + $1,642.50 + $3,285 + $1,000 = $9,869.50
Step 3
Loan D: $3,942 / $9,869.50 = 0.40
Loan C: $1,642,50 / $9,869.50 = 0.17
Loan B: $3,285 / $9,869.50 = 0.33
Loan A: $1,000 / $9,869.50 = 0.10
Fred should use these percentages to pay down all four loans simultaneously, until he makes his final payment. Congrats Fred, you're debt free and you did it using the most cost efficient method!
Way to go, Fred.
Final Thoughts
I encourage you to use the Advanced Debt Avalanche Method pay off your debt. By using these formulas to calculate which loans are actually costing you the most, you can maximize your savings and get out of debt as quickly as possible.
And if you've heard of this method somewhere else, please share it with me! I have yet to find anyone else talking or writing about method, but I can't imagine that I'm the first person to think about this.
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