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 #1)
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.

Taxes

We all want to pay the least taxes possible. With RRSP contributions, and taking courses, and donations I always get back several thousand dollars in income tax in the spring. Starting this year, I will have to re-pay my Home Buyers Plan, which will only be a few hundred dollars from my RRSPs deducted.

The question that I am asking is this: "Is it better to receive several thousand dollars at income tax time" or "Is it better to have your employer reduce the taxes withheld on each paycheque giving you more money every paycheque" or "Is a balance better (a slight drop is taxes and a smaller income tax cheque in March)". I will analyze the three options as best as possible.

Option 1: Receiving money at income tax time - Up until now I really liked this option. Getting an extra paycheque (or two) in March would always do wonders for my net worth spreadsheet and it was nice to put some savings and pay off some loans with that money. The problem is that this is not the most efficient way.

Option 2: Is it better to have your employer reduce the taxes - For ease of calculation, lets assume that I get back $2600 at income tax time. This averages out to $100 per paycheque that the government has taken from me. Mathematically, it makes much more sense (both for my cash flow and total net worth) to have my employer drop by taxes by $100 per paycheque and then get back no money in March. Remember that the government isn't paying you interest on the money it holds, so whether you pay it on credit card bills, or on your mortgage, or invest it, you will be way ahead.

Option 3: Have taxes reduced now and get some back in March - Unfortunately, we really have little idea how much money we will be getting back at income tax time. My biggest fear is always to have to write any cheque, and a cheque to the government in March would not be pleasant. This third option (the one that I will go with) will be to take whatever your income tax credit was last year, and divide it in 2 (and then by 26) and have your taxes cut by that amount each paycheque. In my above example, I got back $2600. I will cut this in half to $1300, and then divide it by 26, giving me an extra $50 per paycheque. In this way, I will also get $1300 back at income tax time. Even if there is a slight change in taxes (positive or negative), there is a guarantee that my paycheque will be larger and I will still get money back at tax time.

Does this make sense? I will go with Option 3, but Option 2 is much more optimized. Leave a comment with your opinion.

Four Books I Highly Recommend...

For those interested in personal finance, or just looking for some inspiration to get their financial journey to retirement started, here are four recommendations:

The Wealthy Barber by David Chilton - the first financial book that I ever picked up and still one of my favourites. The concepts of "pay yourself first" is what is highly stressed in this book, and through the characters and narrative at the local barbershop, it stresses how anyone can end up wealthy. An easy read and very informative!

The Automatic Millionaire by David Bach - very similar to the Wealthy Barber: talks about paying yourself first and the concept of the "Latte Factor", which is the rejoinder to people who say that they are unable to put aside $50 per week for savings. By cutting out the little expenses in your day, you can easily do this! One of the differences between Bach's book and Chilton's is that Bach recommends home ownership as a requirement to being wealthy, while Chilton says that by saving the difference between your rental expenses and buying a home will make you equally wealthy. The difference, in my opinion, is that paying a mortgage is a forced savings, and thus much easier. This book (and its many sequels) is highly recommended!

The Richest Man In Babylon - The concept behind this book is that all of the financial ideas that are popular now have worked for millennia. All of the financial rules about paying debt and saving and investing and ownership versus working are discussed in parable-type debate. I really enjoyed this book, but because of the language it is less personable than the first two on my list. For the frugal among us (and those who can read off the computer), this book is available as a .PDF (because of its age) right here.

Rich Dad, Poor Dad - Another excellent book that will hopefully shift your way of thinking about money. You become rich by increasing your assets. You become rich by ownership in things that make money. A house is not an asset because it doesn't make you any money (for the most part). Money should be working for you rather than you working for money. It is an excellent book because he uses his two "fathers" as comparisons: the formally educated father who has no financial sense but is a hard worker, versus the financially educated father who works hard and is wealthy but has no little education. It is a shift in thinking of putting all of your energy into being wealthy. Before you make a decision, ask yourself "how will this make me more profitable". Another great book.

All of these I read about every six months to re-inspire myself, and I heartily recommend any or all of these to you!

Budgets...who needs them?

I was sitting having a coffee the other day celebrating the end of summer school for another year when I overheard two people in the booth next to me talking about budgets. As I have a keen interest in personal finance, my ears perked up and I listened in.

One person was complaining that her husband was making her have a budget to track her spending for the month. She complained and said that "she felt like she was a kid having to do this". The other person, who was trying to sell her something, was sympathetic, but I thought to myself, "Everyone hates to budget for themselves, so what can be done".

Here is my philosophy on budgets: if you are able to save 10-15% for your retirement and on top of that spend less than you make every month and have no credit card at the end of the month, you don't need a budget. So the question is then, how do we accomplish this?

For most people, some planning is required, and that's why the budget is a good thing. But just by trimming your expenditures each month, or making some extra money on the side, you can do this. For myself, I need to track things electronically, so that is how I track my spending. As well, I now formally have a budget by only spending cash for items. As soon as I run out of cash, I can no longer spend.

The system works for me, but the point is that you have to determine what system will be successful for you. No one likes to be told what to do with your money, because it feels like some of your power is going away. If you can find a way to spend less than you make in a month without a budget, then great! Keep it up! But the reality is that for most of us, we need something to limit our spending.