Minimizing Interest Rates Or Minimizing Monthly Payments?

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A reader named Tom writes in to ask:

You’re always talking about minimizing interest rates when it comes to reducing debt. Shouldn’t you really focus on whatever methods you can use to minimize the total amount that you have to pay each month?

If you look exclusively at your monthly budget and at nothing beyond, it makes sense on some level to merely minimize the total amount you have to pay in bills each month. However, once you start carrying that perspective out to its logical conclusion, it stops making much sense at all.

A very shortsighted scenario. Let’s say Mindy has $1,000 in debt repayment each month and brings in $1,800. It’s very difficult for her to make the payments each month, so she often uses a credit card to pay several bills, reducing her actual debt repayment each month to about $700 and adding $300 to her credit card balance. This means that each month she’s spending only $700 on debt repayment out of that $1,800, which gives her more breathing room for the moment.

However, each time she puts $300 on her credit card, she’s raising the minimum payment on that bill by $15 or $20. This means that the next month, she’ll have to put $320 on the credit card. The cycle continues onward until she reaches her credit limit and then her credit is weak and she has to get another card. The only way she ever escapes from this is by either finishing off a debt or getting a better paying job – if neither occurs, she will be paying debt forever and eventually reach a point where she can no longer pay it each month.

A better scenario. More likely, Tom was actually more interested in looking at a 15 year mortgage versus a 30 year mortgage. Following Tom’s philosophy, one should always take the 30 year mortgage because it affords you more breathing room in your monthly budget. Over the first fifteen years, this is a reasonable philosophy, but then at the fifteen year mark, if you took the shorter mortgage, it’s now paid off and thus the thirty year is eating you alive.

The long view. The best approach of all is to always take the long view with any debt, and the best way to do that is to pay them off in their entirety using the smallest lump of cash possible, no matter the timeframe. The easiest way to look at this is to use the interest rates, because the higher the interest rate, the greater your debt becomes without you doing anything.

It’s also better to always pay more than the minimum payment on whatever your highest-interest debt is each month, even though that means a larger chunk of your monthly budget is eaten by debt repayment. Every time you pay ahead and reduce the total amount owed, the less interest it will build up and the less money you’ll have to pay in the long run. If you don’t have the free money each month to do this, look for ways to reduce the interest rate on your various debts – the end result will be some smaller payments and thus some freed-up money with which to start getting rid of them so debts aren’t a part of your life.

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15 thoughts on “Minimizing Interest Rates Or Minimizing Monthly Payments?

  1. IMHO, here’s a situation I never considered while attempting to repay debt … sometimes lowering your interest rate will allow you to pay the same amount each month, but you’ll pay more to principal since your interest charges will be lower.

    I have a $12,000 car loan @ 7.9%.

    AMAZON has a 4.99% APR on balance transfers for the life of the loan.

    AMAZON will only give me a $8,000 credit line, so I can only pay off $8K of the car loan, thus leaving $4K remaining.

    I’ll have my standard car payment of $306 plus the AMAZON minimum payment of $159.

    I’ll be increasing my payments to ~$470 a month, but I’ll save $250+ a year in interest even after the transfer fee.

    Think it’s a good move? If not, why not?

  2. Tom unfortunately sounds like he would be a prime candidate for being sucked into an ARM with an interest-only option for the first couple years. I hope this is not the case but can see how it would be enticing.

  3. eRock, it is a good move because you are effectively lowering the overall cost to service the debt. If you can handle the incremental $170 monthly payment I would do it.

  4. Tom sounds just like the “$30k a year millionaires” who buy $40k cars because “heck, I’m only paying $500 a month” (for 6 years, at crazy interest).

    I recognize the intended audience of this blog, but sheesh, posts like this just make me shake my head at the current state of financial awareness in this society.

    eROCK, only you can answer if it’s a good move. Strictly by the numbers, yes it is. But if you wind up unable to make the payment in full one month, all your gains will unravel. Oh, and maybe run the numbers on transferring just 4 or 5k to a 0% for 12 month card instead.

  5. Writing an little post similiar to this in a few days just havent gotten around to it yet. But interest is a killer, I think it is better to attack your bills upfront rather then opt for the low monthly payments…It will leave you short changed now but Pay-off in the long run…

  6. What if, with the mortgage situation, one did a hybrid approach? That is, take the 30-year mortgage with the understanding that any extra payments you make go towards the principal, not interest. Then, whenever one had more breathing room than was required in the monthly budget, one would send in double or triple the necessary mortgage payment. If one was feeling a bit “short” that month, one could then make only the minimum payment.

    Would this be foolish, or a “best of both worlds” situation? I suppose it depends on how committed one is – and how many times one does – pay extra on the mortgage.

  7. My grandfather always said ‘The road to hell is paved with Easy Payment Plans,” and I’ve tried to take that to heart. My husband and I live on his salary and although we’ve aquired some substantial credit card debt (because of life throwing some pretty tough curve-balls our way) we’ve never been prone to using the cards for spending or luxuries, only for survival and true emergencies.

    My sibling, however, and their spouse live a high-life lifestlye courtesy of Visa and MasterCard. They’re always bringing home the newsest thing, wearing stylish clothes, and driving new cars. They’re also both working full time plus at least one part time job each just to make the minimum payments.

    I’ll take my paid-cash-for-it car and quiet eat-at-home life over theirs any day. We always pay extra on our debt (all moved to low interest for life cards) and it’s steadily shrinking. My sibling’s family makes more than three times as much as we do, but all they do is work and dig a deeper hole. From my vantage point it’s MUCH better to pay extra instead of being suckered into the ‘oh, it’ll only cost us $20 more a month’ midset. That just digs a deeper and deeper hole. It’s sort of like the story about cooking a frog. Put a frog into a hot pot, he’ll jump right out. Put him into cold water and slowly turn up the heat, he’ll sit there and cook.

    Debt’s the same thing, at least from my experience.

  8. There are times in our lives when cash flow is more important than wealth creation — such as when someone is in school. My wife is in grad school now, and we’ve taken a cash flow oriented look, knowing that she will make more money when she is done, we can focus on wealth creation. That being said, we have no debt but our 30-yr mortgage.

  9. Amanda,

    You hit the nail on the head… it depends on how committed one is, and how many times extra is actually paid. Unfortunately, many folks that take that route seem to very regularly come up with reasons that they can’t make the extra payment this month, taking the “maybe next month will be better” approach. Invariably, it rarely seems to… and so, they very rarely make the well intended “extra” payments. It’s not a bad idea at all… just an easy one to talk yourself out of on a month to month basis!

  10. A few years ago when I had to refinance my car, I followed an approach similar to Amanda’s, except I took it one step further:
    1. I checked how much the monthly payment for the 2 year plan was (and made sure I could afford it)
    2. I signed up for the 5 year plan (with a somewhat higher rate).
    3. I set up an automatic transfer for the amount due in the 2 year plan.
    I found this made it much harder to come up with excuses for not paying the higher amount, since I didn’t even have to think about it most of the time, but it still gave me the freedom (which I did take a couple of times) of paying less on a given month.
    Sometimes, self discipline can be outsourced… :)

  11. Simple Method:
    1. Pay off Minimum each month + a little over it (as much as you can afford to);
    2. Look for cards with lower interest rates.
    3. Apply and get one.
    4. Transfer balance.
    5. Repeat 1 to 4 till debt is paid off.
    The lower the interest the faster we shall pay off the debt (Thumb Rule).
    Cheers,
    FIRE FInance

  12. The time it takes to pay off a mortgage or a credit card is just as important as the interest rate, because of compounding.

    Let’s say that you took out a 30 year mortgage of $300,000.00 at 7%. Tht total interest you would pay would pay over 30 years is $418,527.60- more than the original loan! Your monthly payment would be $1,995.91.

    If you took out a 15 year mortgage in the same amount and interest rate instead, your monthly payment would be higher- $2696.48 per month. Your total interest paid on the loan over 15 years would be much lower- $185,366.40, saving you a total of $233,161.20 in interest. This is because you are borrowing the money for a much shorter period of time.

    You can ususally get a slightly lower interest rate for a 15 year mortgage, saving you even more interest.

    After the 15 year loan is paid off, you have freed yourself from 15 years of mortgage payments! This gives you a lot of freedom to decide whether to retire, change careers, etc.

    However, if you want more flexibility, in case you lose your job or become disabled, you can get the 30 year loan, but make payments as if it were a 15 year loan. This way you will get the loan paid off in 15 years, but you can fall back to the smaller payment if you need to. You should set the loan payments- at the amount needed to pay off the loan in 15 years- as an automatic payment. Then you won’t be tempted to change the amount unless you really need to.

    I have a 15 year mortgage and have been paying an extra $250 per month on it since the very first payment on the loan. It will take just under 13 years to pay off the 15 year loan. I have 9 years left, then I will be free!

  13. We had a 30 year note for “safety room” reasons…my husband and I are both self employed.
    We did pay it off in under the fifteen year mark by putting all extra money toward it. Then the real estate taxes doubled and our health insurance doubled in the same year. Fortunately our town passed an ordinance to allow “in law” apartments but the renter doesn’t have to be a relative. We rearranged our living quarters and have been able to get 700 a month to help off set the increased tax and insurance. This web site helps me to stay current on ways to get ahead and ways to stay out of debt.

  14. When I first read Tom’s comment, I thought he meant it’d be good to focus on minimizing other monthly costs, to free up more to pay toward the debt.

  15. I always like to take the long term view and personally for me this means paying off as much debt as possible, particularly as credit interest rates are usually subtstantial. Yo have to bear in mind that the quicker you pay it off, the less interest you will be charged and this can only be good for your finances

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