Most people in America have some type of debt they owe and most want to pay it off but are not very smart about it. The majority of people that do not make the best choices for themselves are not always at fault. There are some advisors that just give bad advice.
Last year there was a radio ad promising to teach you how to pay down your debt, no matter how big, with only the money you already make. This isn’t possible for everyone. Some people do owe more than they can ever possibly repay.
This system starts off in exactly the right place. The first thing to do when faced with debt is to stop the bleeding. Lay out a budget, use coupons, even cancel or downgrade services like your phone and cable. The materials teach the wrong message however when it comes to what debt to pay in what order. This advisors system recommended that you pay off the smallest debt first. Once the smallest debt is paid entirely apply that monthly payment to the next smallest debt and so on until they are all paid off.
Responsible advisors and research from the Universityof Michigan's Ross School of Business claim that such advice actually makes it harder to dig out of debt. People like to pay off their smaller debts first because of a phenomenon called debt account aversion. When an account is paid off you feel accomplished. Just like when you look at your list of to do items and you do the easiest items first.
The problem with this tactic is that it does not take into account issues like interests rates. If the smallest debt also has the highest rate then it does make sense. Paying the debt with the highest rate first is the way that will cost you the least amount of money; thereby allowing you to pay off the total debt the fastest.
Lilly E. of Silver Spring, MD found herself in over her head with her three credit cards and has agreed to share her situation as an example.
Card A ~ $1000 at 6%
Card B ~ $2000 at 18%
Card C ~ $5000 at 28%
If her Minimum payments are 3% of the balance and she has $400 to apply to her debts each month paying off the smallest card first she pays her last bill in month 28 costing a total of $10,668.60. If she pays the highest interest first her last payment is in month 23 costing a total of $8,919.95.
Debt can be useful thing in some situations like buying big ticket items, a house or a car but it is not the way to pay for your day to day expenses. Make sure you use debt responsibly so this lesson is one you don’t have to learn the hard way.
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