How They Say to Pay Off Debt

Most financial experts will give you a very straightforward method to pay off your debt.

You begin by dividing your debt into “good debt” and “bad debt.” Your good debt is investment stuff — mortgages, student loans, whatever. The bad debt is the high-interest stuff — mostly credit cards. The idea is that your good debt is stuff that it’s ok to pay interest on, and stuff where the interest isn’t that high. If you’re paying student loan interest at 3.5% or whatever, it really isn’t that much when you think about it. It’s more than 0, to be sure, but it isn’t as high as some credit cards.

The bad debt is obviously what you want to pay off first — paying 15-20% interest is painful. Debt can be further divided into two categories: principal and interest. The principal is what is actually owing — say you borrow $1000 to buy something worth $1000. Great, there’s your principal. The interest is the fee you’re being charged, essentially, to borrow that money. Over a month, this isn’t too big a problem, depending on your interest rate.

Say your interest rate is 19.5%. To calculate the interest, what you would do is this:

19.5/100 = .195 (this makes it a percentage)

.195 / 365 = .000534 (we want the daily rate)

.000534 * 1000 * 30 (daily rate, times borrow amount, times number of days)

This gives us the “simple” interest amount for $16.02

For compound interest, it’s basically the same, except the last step increases every day.

Day 1: .000534 * 1000 = .534

Day 2: .000534 * 1000.534 = 1000.534285156

Day 3: .000534 * 1000.534285156 = 1000.534285308273304 …

Day 31: 1016.161

You can see you only borrowed $1000, but at this point, on day 32, you’ll be paying $.09 interest on interest. It’s a charge on a charge! Madness.

You can see that you’re paying interest on interest — if your card rolls month to month especially, unless you’re paying down the principal significantly, you end up essentially being charged for being charged! This is not a good spot to be in to say the least.

So, obviously you want to pay down the card with the highest interest rate, first. Were you to focus on a debt with a 3.5% interest rate vs one with a 20% interest rate, you’d obviously wind up paying much more interest on the latter than the former on a ratio of principal:interest.

Next, experts would argue that you pay down the highest debt first, the idea again being you want to pay the least interest possible, but here’s where I disagree. I feel from a psychological standpoint, it’s more freeing to pay off the smallest debts first — using myself as an example, my first goal is to pay off my card with $1603.76 remaining. Not the ~$3000, not the ~$4000, but that one. Granted, I’ll pay more interest in the long term, but I feel that it’ll be more psychologically rewarding and will encourage me to roll to the next one. That’s just me, though.

I do agree with the first steps though. While the best debt is no debt, you need to remember there is good debt and there is bad debt. I don’t even think about my student loans — I pay off the payment every month, and that’s it. Since the interest rate is so insignificant next to the credit card debt, and because I have a shiny degree to explain why I owe so much, I’m ok with that. Being at peace with some of your debt is a great way to start down the road to being totally debt free — as long as you remember that some debt, no matter how small, is not good.