Monday, May 15, 2006

Debt Reduction Methods

I have a lot of debt. My general approach is to make the minimum payment on everything except the debt with the highest interest rate, and then apply additional money to only that debt. (In other words, if my total minimum payments are $200 and I have $300 available, the extra $100 goes to the highest-interest debt.)

But occasionally I run into a different idea about this, which is that you should prioritize the debt with the highest ratio of minimum payment to total balance. Today, Get Rich Slowly has a link to this explanation of the DOLP method, which is basically that idea.

It's counterintuitive to me that paying off the highest-ratio-of-payment-to-balance debt would be faster and cheaper, overall, than paying off the debt with the highest interest rate. So I tested this in Excel.

I assumed that I had two debts of equal amount ($5000): a credit card at 15% APR with a minimum monthly payment of 2% of the balance, and an installment loan at 10% APR with a minimum monthly payment of a flat $300. This gave a large separation in that DOLP ratio and a reasonable APR separation. I applied $700 per month under each scenario.

Both scenarios got the debt paid off in the same month, but my highest-APR-first plan was cheaper by around $200!

So I thought, maybe a 5% difference in APR is too much, and I lowered the credit card to 12% APR. Now the difference shrank to $40, but it still came out in favor of my method.

Stupid DOLP. The only advantage I can see to it is that you do get your first debt paid off faster under it; under my plan you spend more time making payments to every debt (5 months more, in my simulation). I guess getting individual debts written off (and hopefully cancelling the cards or otherwise ensuring that you don't just charge them back up) is psychologically satisfying and might motivate someone better. And the cost difference was not extreme. But still, I think I'll stick with my method.

1 comment:

Debbie said...

Exactly, it's all about the psychology. It works even better when you just pay off your smallest debt first. You get that feeling of success early on that helps motivate you to continue. Some of us can get a lot of help from weird crutches like this.

Those of us who don't need that should go with the rational, and that's you. I did the same thing with my student loans.