Question from a Globe and Mail reader: I currently have a $17,000 car loan at 0 per cent, which is costing me $400 a month. I also have a $20,000 line of credit at 6 per cent interest. I just inherited $12,000. What is the best way to deploy that windfall? Does it make more sense to pay down the line of credit first as it will only cost me more money the longer it sits – approximately $130 each month in minimum interest charges, or do I pay the car down as fast as possible? Then I will have an additional $400 a month to pay down the line of credit.
Answer from Shannon Lee Simmons, a financial planner and founder of The New School of Finance in Toronto: The age old debt advice is: Put your money toward the highest interest rate debt first. While this certainly is sage counsel, there is one exception. If you’re sliding further and further into credit card or line of credit debt it could mean that your existing debts have minimum payments that are so high that you don’t have a sustainable amount of spending money to live your life and pay debt at the same time. This dooms you to fail and the more often you fail, the more likely you’ll keep spending and being in debt rather than ask for help. It may cost more and take more time, but it could be worth it to avoid being stuck in a debt loop forever.
Shannon Lee Simmons is the author of the book Worry-Free Money: The Guilt-Free Approach to Managing Your Money and Your Life.
The traditional way: Attack highest interest rate first
You put $12,000 onto the line of credit and continue to pay only the $130 per month. You also continue paying $400 a month to your $17,000 car loan and once either debt is paid off, you put the freed up minimum payment toward any existing debt. This strategy is called Debt Stacking or Snowballing.
Car loan: Paid off in month 42 (3.5 years), freeing up $400 per month with $0 interest paid.
Line of credit: Paid off in month 49 (just over four years), freeing up $530 ($400 plus $130) per month with $1,345.35 interest paid.
Once the entire Debt Snowball is done, you get $530 back into your pocket ($400 plus $130).
Paying the lower amount first:
You put the $12,000 onto your 0% car loan and continue to pay the $400 a month. You also continue to pay the $130 to your line of credit until you are paid off the car loan. Then, you put $530 a month toward the line of credit.
Car loan: Paid off in month 13 (just over a year), freeing up $400 a month with $0 interest paid.
Line of credit: Paid off in month 54 (4.5 years), freeing up $530 ($400 plus $130), with $3,413.62 interest paid.
Comparing the two methods, you pay over $2,000 more in interest and you take five months longer until you’re debt free by paying the car loan first. So, paying down the highest rate of interest first makes the most sense on so many levels.
But, if you’re in a situation where your line of credit goes down and then back up again, you may want to take the hit on the interest and pay off the lower amount. Why? Because, if you’re stuck in a debt loop, you may not have enough money each month to cover all your needs and you keep paying down debt only to rack it back up again. If you put the $12,000 onto the car loan first, you’ll free up $400 in only 13 months. Then, you can actually use some of this, let’s say $200, to pad your pockets each month and give you a bit more financial breathing room and reduce the chances of you going back into debt later. You keep $200 for your own spending money and add only $200 to the Debt Snowball, making the payments to your line of credit $330 ($200 + $130).
Under this plan:
Car loan: Paid off in month 13 (just over a year), freeing up $400 a month with $0 interest paid.
Line of credit: Paid off in month 85 (just over seven years), freeing up $330 ($200 plus $130) per month to go to debt, $4,999.08 in interest – freeing up $200 a month to create sustainable cash flow for yourself each month.
The difference is around $3,600 in interest paid. That’s not chump change. That’s why the only time you do this is if you are going into more and more debt each month and you need cash flow to live your life so that you don’t sink further into the hole and actually start to make progress. If you can’t actually afford to put the full $530 ($400 plus $130) toward your debt each month, then the cheapest plan above is moot.
It always makes more financial sense to pay down the highest interest rate debt first, regardless of the amount owing. However, if you’re sinking into debt or can’t afford your life as it is, I give you permission to pay off the lower amount first so you can free up cash flow and create a more sustainable and realistic plan that will actually move you forward rather than a plan that has you moving one step forward, one step back.
This method may take you longer and you may pay more in interest, but it will keep you motivated to stick with the plan and see it through to the end because you know you can live and pay down debt at the same time. That’s what I call a win.
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