Many people have several debts and classes of debts. Sooner or later, a debtor may consider digging themselves out of their debt obligations. In order to reduce your debts, each month there is a decision to make: to accelerate this process, which debt should I choose to make a payment larger than the minimum payment?
You can rank your debts by the highest interest rate, the smallest debt amount, or the largest debt amount to select the first one to pay down. None of those methods are correct. The optimal way to pay down your debts is to rank them based upon the ratio of the payment to the debt amount. This ratio measures how much or how little a particular debt is impacting your personal cash flow. Debts with a high relative payment are inefficient to your monthly cash flow while debts with a low relative payment are economical to your monthly cash flow. In general, the higher the interest rate and the shorter the loan term, then the debt payment is more inefficient. When you pay off one of these inefficient debts, then it has a greatest relative improvement upon your monthly cash flow. Extinguishing this debt will free up relatively more money to be available to pay down the next most inefficient debt.
There are several different ways to calculate this ratio. For example: annual payment/debt balance or debt balance/monthly payment. It really doesn’t matter. The point is to select a calculation method that works for you and apply the same calculation to all of your debts to rank them consistently. Let’s choose the calculation method of: Debt divided by the Monthly Payment for the following examples.
1) Mortgage (30 years at 5%)
Balance $180,000
Monthly Payment $996.28
Ratio = 180.6
2) Auto Loan (4 years at 7%)
Balance $20,000
Monthly Payment $478.92
Ratio = 41.8
3) Credit Card (at 16%)
Balance $8,000
Monthly Payment $213.33
Ratio = 37.5
To understand the meaning of the ratio, it is measuring the size of the payment to the outstanding principal balance. When comparing debts, the lower the ratio infers that the payment is a large amount compared to the balance. When a payment is large to its balance, then it is consuming more of your monthly cash flow.
Using this ratio, the mortgage has the most efficient payment schedule and the credit card has the least efficient payment schedule. In this case, the optimal debt to apply extra principal payments is the credit card. Once the credit card balance is paid off, the next most inefficient payment is the auto loan. So the $213.33 that used to pay for credit card interest, plus the additional principal payment you were making, should now be applied to the auto loan principal. One by one, knocking out these debts, including your home mortgage, frees up your monthly income to increase your contributions to savings, investments, and spending.