Which debt to pay first
All debt is not created equal. Sal Khan of Khan Academy explains exactly why you should always try to tackle higher interest debt first.
If you have multiple loans outstanding or if you have multiple debts, there's a general principle that you're going to minimize your total payments, you're going to minimize your total interest paid if you pay your higher interest debt off first. But to make that a little bit more tangible, we've set up a little spreadsheet here to make that comparison, to show the scenarios of what happens if you pay your higher interest debt off first versus what happens if you pay your lower interest debt off first.
And to make that comparison, we've assumed someone who has two debts that they're going to pay or they're going to try to pay down. They have a student loan. The amount that they owe, the principle owed is $2,000 on the student loan, and to make the comparison clear, they have the exact same amount owed on their credit card. And we're going to assume that every month, this person has a $400 budget with which they could pay the student loan and the credit card.
Now, we've made some assumptions about minimum payments. We have a $50 minimum payment on the student loan, $40 minimum payment on the credit card. And once again, depending if you have a student loan or a credit card debt, it might be a slightly different minimum payment, but this is indicative of the types of minimum payments you might see.
And so in a given month, they definitely have to pay $90 -- $50 to the student loan, whoever lent them the money for the student loan, and $40 to the credit card, but then they have another $310 to say, "Well, what do I do with the rest?" And so there's two scenarios. They could put all of the rest to the student loan, in which case they're going to put $360 to the student loan, and that would be the case where they're paying the student loan first, or they're paying the lower-interest debt first. Or they could put the rest of the money towards paying the credit card, in which case they would be paying $350 for the credit card and just make the minimum payment on the student loan.
And once again, paying the credit card off first, that would be consistent with that rule of thumb that I said at the beginning of this video. The credit card, at least here we've assumed, is a higher interest rate, 15% versus 6.8%. Once again, your particular circumstances or anyone's particular circumstances are likely to be different but this is indicative.
And just to understand what all of these other things are, this looks like a fancy technical term r-factor, but all that is is if you take the interest rate, which is an annual interest rate, and you divide it by the number of days, and the number of days in a year is 365.25. This actually takes into account leap years. So 365.25 days, you take 6.8% and divide by that, you get this number, and that's useful because that's how much interest is going to compound on a daily basis. You could view this as the daily interest rate, which is actually how the interest is calculated for most of these types of loans. So this is the daily interest rate for the student loan. This is the daily interest rate for the credit card.
So now that we have all the assumptions out of the way, let's look at the two scenarios. So let me scroll down here, and so we have scenario 1, student loan before credit card. Now is that consistent with the rule of thumb? – No. The rule of thumb is your credit card is higher interest, at least in this scenario, so what the rule of thumb would say, you should maybe do what scenario 2 is saying, credit card before student loan, but let's just make sure. Let's not just take the rule of thumb at face value. Let's actually digest why that rule of thumb makes sense, especially for this scenario.
So just to understand this model, each column here, they're calling it that's the period but the period that we care about is a month, and we go all the way out to 11 months, and actually the model continues out beyond that. Now for each of our debts, they list the principal outstanding. That's how much you owe at the beginning. That's how much you owe in that period.
So for example when you're starting off, we're owing $2,000 on the student loan, $2,000 on the credit card, and then as we make payments, and we're going to think about the payments in a second, some of that goes to interest and some of that goes down to actually pay down the actual debt. Remember, we're paying the student loan before credit card, so we're making the minimum $40 payment on the credit card, $15.36 of which is going towards principal, so actually paying down the $2,000, and the rest of the $40 is going down to interest, and so you see in the next month you owe $2,000 minus $15.36 which is this number right over here.
So if you're paying $40, the minimum payment on the credit card, and you're trying to pay the student loan off first, you're using the remaining $360 to pay this off. So you're paying $360. $348.83 goes to principal and then $11.17 goes to interest. And so you see in month 2, you no longer owe $2,000. You owe $2,000 minus $348.83, the amount that you paid down principal.
So when you pay the student loan first, you're seeing every month we're making a $360 payment right over here, and we're paying it down fairly quickly, and then once we've essentially paid down, we've completely paid down the student loan, and you can see right over here in month 6, we don't even have $360 to spend. We only have to spend a little over $235 or actually a little over $236, then we can start using the rest of the money to pay down the credit card because obviously we want to pay that down eventually as well.
So that's scenario 1, and we're done essentially paying down the credit card by month 11, and we see our total interest paid is $245.22, and you can view the total interest paid. That was the cost of the debt. That was what it cost you to essentially rent the money from each of these lenders.
Now let's look at scenario 2, which is what the rule of thumb would tell us, pay the higher interest debt off first. So here we're making the minimum payment on the student loan. We're making that $50 minimum payment on the student loan, and we're using the remaining $350 to pay the credit card. So in month 1, $325.36 goes to principal, the remainder goes to interest, and then we keep doing that. We pay the credit card down first.
Essentially we are pretty much done paying down the credit card by – you can kind of think this 5 cents here is kind of round-off error – definitely by the 6th month and then a little bit on the 7th month, but by the 7th month we're able to, since we've paid down the credit card, we're able to put most of our payments back towards the student loan, and then once again we are done paying that off by month 11.
So it took us roughly the same amount of time but look at the total interest paid. Once again, the total interest paid is going to be the sum of this row and this row and this row right over here, and when we paid the higher-interest debt off first, when we paid the credit card debt off first, we paid less interest. We paid $177.47 versus $245.22, and once again, this is for these particular circumstances, for these interest rates, for $2,000.
If the numbers were larger, then these numbers would be bigger, and then the differences were bigger; and if the interest rate differences were bigger, then these differences would be bigger. But hopefully this gives you some confidence that you don't just have to take the rule of thumb on faith, that the numbers actually work out, that when you pay the higher-interest debt off first, you're going to pay less aggregate interest.
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