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Friday, July 31, 2009

Analyzing Paying Off Loans

We all have loans that we have to pay off. The question always rests with us is "which should I more aggressively pay off"? This post will analyze some of your options.

Option 1 - Pay more than the minimum on all loans We all know that by paying just the minimum on your loans it will take forever to pay them off. This option suggests that you pay more than the minimum on all your loans. Let's say that you have loans with minimums of $96, $105, and $113, every time you get a raise you will split the difference equally. So if you get a $60 raise, your new payments will be $116, $125 and $133 (a $20 raise to each).

Option 2 - Pay more quickly the one with the highest interest rate - This is the mathematically best way to go. Whatever loan has the highest interest rate (usually your credit card) you should put the priority on. So in the scenario above, with minimums of $96, $105, and $113, you should put your extra $60 to the one with the highest interest rate, and pay the minimums on the rest of your loans. As I said, mathematically this makes the most sense.

Option 3 - Pay off the lowest valued loan first - The theory behind this is that the reason that people have loans is because of cash flow problems, so your efforts should be to pay off the loan that has the least value, thus increasing your cash flow and then you can put this money towards your other loans. The second benefit is that you feel good for each loan that you pay off. My example will be three loans: one for 3% for $3000, one for 5% for $4000 and one for 7% for $5000. This option says to pay off the $3000 one first, to improve your cash flow and then put the extra money that you have onto the $4000 loan.

Option 4 - Dead On Last Payment - This is recommended by David Bach in "The Automatic Millionaire" when choosing between which bills to pay. The following table is taken from page 181 from his book:

Account Outstanding Balance Monthly Minimum Payment DOLP (Outstanding Balance divided by
Monthly Minimum Payment)
DOLP Ranking (Lowest DOLP number is ranked
Visa $500 $50 10 1
MasterCard $775 $65 12 2
Bay Card $1,150 $35 33 3

The idea behind this is that it combines the highest interest and the lowest value of the loan. You should pay the minimums on all your balances and all your extra money on the loan with the lowest DOLP. Another good option.

For me, my personal priorities are to pay my credit cards off first (since the interest is triple my other loans) and then to pay off my lowest valued loans after that. Feel free to comment and share what your strategy is to paying off debt.

Edit: Sorry about the spacing with the table. HTML doesn't quite work perfectly in this blog.

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