Debt and Freedom

A few days ago my friend left his job. He was offered a different job at his place of business and turned it down and now decided that he isn't going to look for a job for the rest of the year.

The first question that he was asked is how can he afford to do this. He stated that he has enough money put away that he can handle two years of expenses. His life was set up though to have minimal expenses: no education loans, no mortgage, no vehicle, etc.

How does this affect me? I have lots of expenses/bills/loans and would never have the freedom to take four or five months off to re-evaluate my life because of this. I guess what I am asking (or wondering) if I should stop saving and put all my money into paying off loans to achieve this freedom?

I know that long term you have to look at the potential returns, but by paying off loans you are paying off a fixed rate, and thus its a fixed investment that you are paying. This year, with my raise, I put 25% into investments, and 50% into debt repayment (leaving 25% float for myself), so I think I am concerned about paying off my debt, and I have decided that any tutoring money that I get this year will also go towards debt repayment. Realistically though, I am about three and a half years away from this kind of freedom. The only difference between my friend and me is that I have decided to take on a mortgage, and because of this my net worth is better, but my short term freedom is reduced.

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.