Your Money_ The Missing Manual - J. D. Roth [31]
Car loans are borderline: They generally carry low interest rates, but as you well know, cars lose value the moment you drive them off the lot.
Even when you take on these kinds of "good" debts, be smart. Don't borrow more than you can afford. Shop around for the best interest rate (see Chapter 7 for more on this). And remember: The best debt is debt that's paid off.
Destroy Existing Debt
After you've stopped using credit and created an emergency fund, then go after your existing debt. Attack it with vigor—throw whatever you can at it. The best way to do this is to use a technique called the debt snowball, which lets you build and maintain debt-destroying momentum. Here's the basic method:
Make a list of your debts in the order you want to destroy them. (You'll learn a couple of good ways to prioritize debts in a moment.)
Set aside a certain amount of money to pay toward debts each month ($500, say).
Make the minimum payment on all debts except the first one on your list.
Throw every other penny at the first debt on the list.
But here's the key to making the debt snowball work: After you've destroyed your first debt, you'll find you've freed up a bit of cash; because one of your debts is gone, you have one less monthly payment. You could take this money and use it for something else, but you're going to do something smarter: keep paying the same total amount—$500, in our example—toward debt every month.
Clear as mud? Let's look at a couple of examples that prioritize debt reduction in different ways.
Destroying high-interest debt first
Conventional wisdom says that you should pay off debt from the highest interest rate to the lowest interest rate. Let's say our friend Joe Spendsalot (Cash Flow Basics) is dating a woman named Karen Kashout. Karen is a typical twenty-something who wakes one morning to realize that she's in debt, and she decides to do something about it. She's burdened with the following liabilities:
$20,000 student loan at 5% interest
$8,000 credit card balance at 12%
$2,000 computer loan at 10%
$3,000 car loan at 4%
Technically, the quickest way for Karen to conquer her debt is to pay off the balances with the higher interest rates first, so she'd tackle them in this order:
$8,000 credit card balance at 12%
$2,000 computer loan at 10%
$20,000 college loan at 5%
$3,000 car loan at 4%
Using the debt snowball method described above, Karen would pay the minimums on the bottom three debts and throw all the money she could at her credit card balance. Once she destroys that debt, she'd pay the minimums on the bottom two debts and throw all of her money at the computer loan, and so on.
Mathematically, the high-interest payoff plan does indeed make the most sense. That's because paying interest works against you in the same way that earning interest works for you (see The Power of Compounding), so paying off your highest interest debt first is technically the best use of your money—if you follow this plan, you'll pay less in the long run. But this plan works only if you have the discipline to stick to it, and even if you know it's the right thing to do, that's no guarantee it'll work for you.
I struggled with debt for a decade (see the box on The Basics of Debt Reduction). I made several attempts to pay off my debt using this highest-to-lowest interest method, and each time I failed. My highest interest rate debt was also my debt with the highest balance, so I felt like I was paying and paying but the balance never dropped. I'd get discouraged and give up on ever paying off my debt.
That's not to say you shouldn't try this method: If it works for you, use it! But if you struggle, consider the next method, which is the one that helped me succeed.
Tip
It might help you to have a visual representation