How to Improve Your Bottom Line by Eliminating High Interest Debt

  • October 23, 2018
  • by Emily
How to Improve Your Bottom Line by Eliminating High Interest Debt

Debt is a useful tool to meet personal and financial goals like homeownership or going to college. But interest, especially if the rates are high, can cripple your efforts to pay off loans and make progress towards a healthy budget and higher net worth.

Reducing the amount you’re paying towards interest is a key part of budgeting and building net worth. You can make interest work for you through investments, rather than work against you in the form of debt interest. There are two basic ways to reduce the amount of interest you pay.

  1. Reduce the interest rate on your debt

    and/or
     
  2. Pay off the debt entirely
     

Refinancing

Whether it’s a home mortgage or student loans, refinancing can make sense as a way to reduce the amount of interest you’re paying. Depending on the type of debt, part of your refinance strategy could be to consolidate several loans into one loan with a lower interest rate.

If you think you’ll still take several more years to pay off the debt, refinancing can lead to substantial savings. For example, a 1% reduction in your interest rate on a $300,000 mortgage will reduce your monthly payment by about $200. Our loan calculators can help you determine the exact savings given your situation.

When you’re thinking about refinancing, remember that extending the length of time your debt is in repayment will ultimately increase the total amount of interest you pay. So if the goal is paying less interest overall, you should refinance to decrease the percentage of your monthly payment that goes to interest but use the savings on interest to pay off the debt sooner.

Paying Off Debt

When you’re browsing the snazzy pages dedicated to refinancing student loans, it’s easy to get caught up in the refinancing glamour. But the way to pay less interest on debt is to get out of debt, period. Refinancing is a tool to help you do that, but there are also ways to budget to get out of debt.

There are two popular ways to pay off debt:

  1. The snowball method
  2. The avalanche method

The snowball method plays more on human psychology than financial strategy. In this method, you funnel all your extra cash towards the debt with the lowest dollar amount. This makes it the easiest to pay off, and provides motivation to keep going—because as soon as you pay off that debt, you move to your next-lowest amount debt.

The downside is that this method doesn’t actually minimize the amount of interest you pay, because it doesn’t take interest rates into account. If I were to do this, I’d pay off my undergraduate student loans that have an interest rate of about 2% first—and that doesn’t make financial sense. But the snowball method is great at giving you small wins that can help keep momentum up.

From a purely interest-reduction perspective, the avalanche method is better. This involves identifying your highest-interest debt and funneling all of your money towards it while paying the minimum on everything else. The avalanche method, also called “stacking,” won’t necessarily give you quick wins but is the best way to reduce the total amount of interest you pay on your debt over your lifetime.

Debt reduction strategy comparison:

 

Avalanche

Snowball

Strategy

Pay off highest interest debt first

Pay off debt with smallest balance first

Interest Payments

Minimized

Not as efficient as avalanche, lenders get more out of you

Psychology

Requires patience

Easier because of quick wins

Budget

Better for long term net worth

Frees up cash sooner


 

The bottom line is that paying less interest on debt involves reducing your interest rates, through refinancing or consolidation, whenever possible and paying off your debts, ideally by paying your highest-interest loans off first.

It’s also important to remember that paying off debt is something you should do strategically. Remember those undergrad student loans I have, at a 2% interest rate? From a financial perspective, it makes the most sense for me to pay the minimum on those loans while investing and/or saving for retirement, because on average the returns on an index fund investment will be higher than the interest I’m paying on the student loans.

Want to see how your situation would change based on how much money you’re funneling to different financial priorities, including debt repayment? You can use the Income and Spending Simulator to see how those decisions influence your net worth in 5, 10 or 20 years.

The post How to Improve Your Bottom Line by Eliminating High Interest Debt is part of a series on personal finances and financial literacy published at Wealth Meta. This entry was posted in Personal Finance, Budgeting
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