Thursday, July 20, 2006

Paying Off Your Credit Card Could Cost You Hundreds of Dollars

Most people follow the standard advice of financial planners and other advisors when deciding what debt to tackle first. This advice is usually fairly basic: pay off the highest interest debt first (usually credit cards) and continue to take that same monthly payment and apply to the next debt etc down the line until all the debt is paid off. But recently I considered this I am getting ready to start paying down principal on my student loans and last credit card.

I discovered that this advice is not true for everyone, especially not in the case of a windfall. The reason that this is not true is because of the doom that compounding interest can bring. Here's a simple example to show you why time, not just your interest rate, should be a big factor in deciding your lump-sum payoff targets.



Scenario

There are two loans: one at 17.5% (a credit card with a 2000 balance) and a personal loan at 7% that has a 10000 balance. Each debt has a normal payment - the credit card is 125/month and will be paid in 19 months. The loan payment is 150/month and will be paid in 85 months.

All of a sudden, a 500 windfall (taxes, lottery, gift) comes in and you decide to pay debt doing a lump-sum paydown. For most people, the choice is a no brainer - the credit card. It has a higher rate. However, in this situation, some calculations show that even though the interest rate is higher, the actual monthly amount of interest accruing on the credit card is LOWER than the loan.

And in this case, it is a dramatic difference since the loan has an average of 31.78/month and the credit card has an average of 15.42/month. This means that the amount of accrued interest is close to twice as much on the loan as on the credit card.


Since this is a windfall (a one time extra), the rule of being able to "snowball" doesn't really apply. The idea of snowballing is that each paid off bill provides more extra income to pay down the next debt. However, this is a windfall that will not come in again so there is not any "extra" income that will be realized next month unless this lump-sum paydown will end your obligation.

So, instead of the instant payoff, you simply consider how much money that this will save over the life of the remainder of the debt repayment. In the case of the loan, you would save about 286 dollars whereas only about 108 dollars would be saved on the credit card.

Even the hybrid scenario doesn't work out better. That is, in theory, if you put the money on the card and took the "extra" 108 dollars from the savings on the card and put it on the loan right away, you would still save only about 58 extra dollars for a total of 166, which is still less than the 286 that could be saved by tacking it onto the loan directly.

The reason that this is important is not just the time (years) it will take to repay the loan, but it is also the large balance. A two thousand dollar credit card is nothing compared to a 10000 dollar student loan.

The bottom line: Total Loan amount and Time to repay the loan are often more important in determining savings (from lower interest payments as a result of a lump-sum paydown) than the interest rate on your loan.

To determine the rate and lumpsum payment on your debts, try using Young Money's Calculator. I use it frequently for the nice reporting feature that shows the amount of interest per payment over the life of a loan using various scenarios.

2 comments:

Ron said...

If I am wrong please correct me, but in my estimation it would still be more beneficial to pay the credit card first since the interest accrued on the student loan is tax deductible for the life of the loan, and the credit card isn't.

jpittman said...

Ron, in my original post, I don't believe I was comparing a student loan. Instead, I was comparing a personal loan at 7% versus a higher rate credit card balance. So there is no tax-deductibility. Also, this article was about a "windfall", that is a one-time amount that you will never get again and is not part of your monthly budget.

All things being equal, loans that have tax-deductible interest are clearly better than ones that don't.

* * *

However, lets assume that there was some tax deductibility. There ARE times when you should still pay down a tax-deductible(TD) loan BEFORE a credit card or other type of loan whose interest is non-tax-deductible(NTD).

This may sound strange, but in a case where the interest paid on the loan(TD) minus the tax deduction is STILL larger than the interest on the loan(NTD) without the deduction AND the deduction does not affect your tax bracket.

Example:

5.5% interest rate for sallie mae tax-deductible student loan (flat payment) = first year of interest is 1650

8.9% interest rate for 4000 credit card balance (not tax deductible) = 356 dollars yearly.

In the case of the student loan, lets assume you have a flat monthly payment for the life of the loan. Graduated payments are trickier and require more monitoring.

Now lets assume that you are in a very high tax bracket - say 40%. In reality, it is probably lower than that. But that means that the 1650 is cut by 40% down to 990 per year. That amount is still more than double the yearly interest on the credit card.

Using a 500 dollar windfall to paydown the credit card is great, and would result in a savings of about 47.50 dollars in interest yearly. Whereas for the student loan, it would save far less yearly: 27.50.

But that's not the end of the story. The difference here, is that for most student loans, the repayment period is about 15-20 years. Over 20 years, the lower amount of 27.50
would become 330 dollars of interest saved (adjusted for a 40% tax-deduction).

Let's say that the credit card is getting paid off at least 50 dollars of principal per month. The savings would last for about 6 years and be 267 dollars, much less than the student loan (even adjusted).

Therefore, in this case, the windfall should go to the student loan over the credit card.

The bottom line - don't assume that your credit card debt should be the first to go when you get a windfall based solely on interest rates. Total amounts of the loan AND length of repayment period must be considered along with interest rates before the best target can be found.

If you or anyone reading this would like more clarification or are trying to consider what to pay off first, I'm happy to help. Just drop another comment here and I will be happy to get back to you!

[edited @1:58 for clarity]