Minimizing Interest Rates Or Minimizing Monthly Payments?

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.