The important thing is to have a system. If you pay your debts in the perfect, optimal order (interest rate high to low), you’ll have your debts paid off approximately one month sooner than if you paid them off in the worst possible order (interest rates low to high). One month! So even if you’re wrong, you win big time.

I am a fan of Dave Ramsey’s and I like to use his methodology often as guidance. I have been following the “pay the smallest balance first” approach only because it keeps me motivated. If I went to tackle the highest interest first, I probably would have given up before paying off the first Card as it was the highest balance credit card I had at the time.

Of course, once that has happened, saving for the future is the next one :-)

Once I had the cash flow problem solved, then I could pick and choose the debt to attack based on interest rate, etc.

My tax refund was unexpectedly large (who knew that you could qualify for the EITC without dependents?) and I was debating what to do with it before it arrived. My two best choices were paying down the signature loan (10.9% APR, fixed, $104 a month) or paying off the Perkins loan (5% APR, fixed, $40 a month, eligible for the full student loan interest deduction) and applying the remainder to the signature loan.

With the voices of my tax accounting and finance profs in the background, I dutifully crunched the numbers. First I annualized. 10.9% APR compounded monthly became 11.46%. 5% became 5.14%. Then I applied 1-MTR. 11.46% remained unchanged but 5.14% went down to 4.15%. According to what I had been taught, everything had to go toward the signature loan.

Then where was this voice saying “Pay off the Perkins loan” coming from? Had months of financial stress and rubbing shoulders with near-innumerate, short-term thinkers really affected me that much? Why was I even considering paying off debt that cheap just to free up $40 a month? I went to bed profoundly confused and upset with myself. My brain was apparently rotting.

By the time the refunds hit my account, I had an answer. My finance prof, and just about every other credentialed money-talker out there, suffered from a going concern bias. Their analysis ignored transaction costs, opportunity costs, and the possibility of default. Unfortunately, it was no longer clear whether I was a going concern. At that time, I had $50 to $100 a month in discretionary income after paying the absolute minimum on my debts, absolutely no savings, and unbudgeted irregular expenses were running about $50 a month. I was paying down debt at a nice clip but I was also perpetually short of cash and it would not have taken much of a bump on the road to send me into the ditch.

In other words, I had become aware of two highly impolite truths. Being broke is damned expensive and defaulting on your debt obligations is ungodly expensive.

Let’s elaborate on how being broke is expensive. Being broke can mean that your bank charges you a $2 bank service charge each month because your checking balance is under $500. Being broke can mean that when the cheapest margarine that you can bear to eat goes on sale for half price, you can only pick up an extra month’s supply. Being broke can mean paying $4 more for a parking ticket simply because you do not have the cash to pay off the ticket within an eight hour window. Being broke can mean that you can only afford to pay your automobile insurance quarterly instead of monthly and the insurance company charges you an extra $3.50 each time they send you a paper bill. Being broke can mean buying coasting into work on Thursday morning on fumes and buying gasoline at weekend prices just to get home that night. A lot of this nickle and dime stuff can be avoided with a little jingle or a little planning, but until you get the hang of planning or have the cash in your pocket, being broke will cost you a whole lot more than the interest rate on your highest debt.

It’s hardly necessary to elaborate on how expensive it is to default on one’s financial obligations. Bouncing a check or being late on a single financial obligation can trigger all sorts of penalties and interest rate increases. The less discretionary income you have, the more likely you are to incur these penalties and these penalties can make the interest that you are currently paying seem absolutely insignificant.

I made a spreadsheet to calculate how much paying off the Perkins loan would cost me. I quickly decided that paying an extra $15 in interest and taxes over the next ten months would dramatically improve my cash flow and dramatically decrease my risk of default.

I’ve never regretted paying off the Perkins loan ahead of the signature loan. With that payment gone, I no longer had to plan my finances three paychecks in advance just to stay afloat. My concerns that I would take the $40 a month and coast instead of applying it to the signature loan were similarly misplaced. It was incredibly easy to put that money toward the signature loan.

Paying off the small cheap loan first was probably one of the best moves that I have ever made.

Praise God I will have the first credit card paid off by the end of this month! I sold my beloved home theater project to do it.

Now if I could only apply the same principal to my eating I could lose that growing gut!!!!

The other thing I noticed about paying off debt – before we did, my husband and I were used to having debt payments as part of our monthly bills – you’ve got rent, utilities, car loan, student loan, etc. But once we paid off all your debt and those monthly payments were gone, I found that I never wanted them back as part of my life.

I’ve been forgetting to be happy when I tick off a debt, so I’m going to stop and do that for a second, rather than just looking at the next one to tackle.

Once I had the cash flow problem solved, then I could pick and choose the debt to attack based on interest rate, etc.

It took us 15 years, but the month after I retired I took my first 457 payment out and paid our last bill – we had bought a used car 6 months before. By that time I had been using my cc to pay for almost everything and paying it off each month. We were 69 & 70, but the rush was still there.

I have refused to have any debt since then. Keep up the good work, Trent, at telling people the good news. On one of your posts someone suggested using your stuff in local high schools and colleges. I think that is a marvelous idea. They learn math, but not money management. Charles Givens, “Wealth Without Risk” had this same idea several years ago. We can’t expect frugal citizens if they can’t learn it at home or at school.

what about that wonderful wife of yours? let’s give the girl a little credit sometimes!

:)

@SteveJ, I love that Lao-Tzu quote. It’s so true!

But depending on ones situation, clearing out many smaller debts can lead to better credit to allow for a loan that could pay off a larger high interest debt and make it more feasible to pay down faster.