In what order should you pay down your debts? For those working hard to get out of debt, it’s an important question. Often we focus on either the amount of our debt or the interest rates. But what if the interest rate on a loan can change, either because it’s a variable rate or perhaps a low introductory rate?
That’s the question a reader named Ted recently asked in an email:
I was wondering if you could provide advice to the debt situation my wife and I currently face. We recently got married and paid for our wedding via a credit card loan. The loan currently stands at about $7,500 and carries 1.9% interest until December 31, 2015. After that it jumps to 11 %. We also have a $15,000 student loan with 9.5% interest, and a $90,000 mortgage (3.5%). Would it be wiser to pay down the loan which currently carries less interest, but has the potential to increase if we don’t pay it off by December? Or should we work on the greater loan with higher interest? It seems like a unique scenario with the potential change in interest rate, and couldn’t decide whether to use the debt snowball or debt avalanche. Any insight you could provide would be appreciated. Keep up the good work on the Podcast, we love it!
The order in which you pay off debt is significant. It determines how much interest you’ll pay, how long it will take to become debt free, and even how much liquidity you’ll have in the process. All of this has caused pundits to debate whether the debt snowball (pay off smallest loan first) or the debt avalanche (pay off highest interest rate first) is best.
In one corner we have Dave Ramsey who insists that everybody should use his debt snowball approach, regardless of the increased interest you may pay. In the other corner we have those who are adept at using a calculator. They tend to focus on just how expensive Dave’s approach can be. Like the first (and best) Rocky, this bout will likely end in a draw.
The reality is that they both have advantages and disadvantages. The debt snowball pays off a small loan quickly, and these small wins can be powerfully motivating. In contrast, the debt avalanche is guaranteed to result in the least amount of interest paid and the quickest path to being debt free.
For those pursuing either approach, one important consideration is debt with variable interest rates. Whether it’s a 0% credit card that will expire soon, a variable rate home equity line of credit, or any other loan with an interest rate that can rise, this factor is an important consideration to creating a solid “Get Out of Debt Blueprint.”
For those facing this issue, like Ted, here are some tips to help you puzzle through this issue.
Debt with interest rates that can change require us to consider 3 key factors.
1. The future rate: The first factor to understand is the potential increase in the interest rate. In some cases this is easy to determine, in other cases it’s not.
For example, it’s easy to determine the future rates on a credit card with a low introductory rate offer. The terms of the card will spell out how long the introductory rate will last and what the new rate will be when the low rate expires.
It’s more difficult with a home equity line of credit (HELOC). Typically the interest rate is set in relation to the prime rate. As the prime rate goes up and down, the rate on a HELOC can go up or down. To complicate matters, HELOCs often cap the the amount the interest rate can go up each year and over the life of the loan.
As a result, there’s no way to predict with certainty when or by how much a HELOC’s rate will rise. But you can dig into the terms of a home equity line of credit to at least understand what the potential rate increase could be.
2. Timing: The next step is to understand when the interest rate will rise. Again, with introductory rates on credit cards, the date of the increase coincides with the expiration of the low rate. With HELOC’s you are at the mercy of the Fed and interest rate markets.
The key is to understand how long you have until the rates on your debt start to rise. While this may not be an exact science, even a reasonable estimate can help you prioritize your debts for repayment.
3. Refinance Options: Even if a low rate expires, you may be able to refinance the debt to a lower rate. The easiest way to accomplish this is through a 0% balance transfer credit card. There are, however, three things to consider with this strategy: (1) these offers require good credit of 700 or more; (2) balance transfer offers change; and (3) you may not get enough credit to cover the entire debt.
Build a Plan
Once you have the above information (or the best estimates you can make), you can start to build a debt repayment plan. As you build your plan, ask yourself the following two questions:
1. How long will it take you to pay off all of your debt?
2. If the rates were to go up on your debt, would you be able to handle the increased monthly payments?
These questions are critical for a few reasons. First, knowing how long it will take you to get a debt paid off helps to understand the risk of potentially higher interest rates. In Ted’s case, for example, the increase to 11% on his credit cards may not be significant if he plans to pay off the card soon. On the other hand, if it will take him several years to pay off this debt, it may be in his best interest to prioritize that debt (even now when it’s at a lower rate).
A free online tool that can help you with your plan is called UnburyMe. The tool enables you to enter your debts, the balance, minimum payment and interest rate. You can also enter the total amount you can apply to your debts each month. UnburyMe then calculates your debt repayment plan using both the debt snowball and debt avalanche methods. You can change the interest rates as well to reflect the potential for higher rates in the future.
Finally, here are 23 additional tools to help you get out of debt.