Ignore interest rates on debt

Photo courtesy of qthomasbower

 

“This card has a 12% APR.”

“My student loan is fixed at 5%.”

“I can get a new car with a 0% interest loan.”

Interest rates are talked about quite often when it comes to financial matters. Mostly, this is because it’s easy; the numbers are usually low, whole numbers, and those are simple to compare.

As I see it though, the importance of interest rates are vastly overinflated, especially when it comes to paying off debts.

Math is not (always) important

Let’s say you have a $10,000 credit card balance at 10%, and a 4,000 car loan at 4%. If you only looked at the interest rates, you’d assume that if you had to pay off one of them first, that it would make sense to pick the credit card. I mean, it’s costing you more money every month that you have it, right?

Well, maybe. But have you actually looked at how much? The results may surprise you.

After a year at 12%, you will be charged $1000 in interest, or about $83 a month. On your car loan, you will be charged $160, or about $13 a month. And while this $70 difference is real, it’s likely not break-the-bank real. (I’m simplifying calculations here for ease of comprehension. I’m trying to downplay math for once.)

But here’s the problem, because the balance on the higher interest rate debt is also higher, if you tackle that one first, you’ll be holding on the other debt for a longer period of time, since you’ll have to keep paying the minimums. That will add up over time.

Forget the math now. Instead, think simplification: how can you simplify your life?

Here’s one idea: how about having to deal with one debt instead of two? One fewer bill. One fewer payment. One fewer thing to deal with and think about. That sounds good to me. How much is that “worth”?

If you pay off the smaller debt first, you will accomplish this much sooner than if you throw everything you have at the large one. And when you’ve paid off the smaller one, you’ll no longer have the minimum payment to worry about, so you can throw that extra money at the big one too.

The math points to paying off the highest interest rate first. I know this. But we are thinking, feeling creatures, and are motivated by more than just the numbers. To me, one of the main reasons to get one’s financial life in order is to feel more at ease. Simplification can accomplish this. And you can work toward simplification right now.

Always exceptions

Now, like any rule of thumb, there are exceptions. If you’ve got something that’s at 200% (don’t laugh, they exist) and something at 4%, you may want to tackle that 200% one first. That’s not a loan; that’s a virus.

But aside from that kind of edge case, I think that if you pursue simplification first and foremost, you’ll find that interest rates aren’t nearly as important as you may have been led to believe.

Agree? Disagree? Either way, I’d like to hear about it below.

Mike Pumphrey

Mike Pumphrey

I'm the founder and author of Unlikely Radical, a site to help people succeed with money, achieve their goals, and live intentionally.

I offer a free phone consultation to anyone who is interested in changing their financial narrative. Are you ready? Click here for details.
Mike Pumphrey
Posted on May 13, 2013
  • Very much agree. Having less things to worry about can be worth a slight premium!

    • Totally! I don’t know how to place a value on peace of mind, but I just try to remember that it does have a value!

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  • Christofu

    I really enjoy your financial advice. “Simplicity” is very powerful and I see it daily at work. My co-workers all tell me stories about the three million things they have to balance, 2.99 million of them self-induced

    • Thank you very much for the kind words, that means a lot to me.

      It is interesting how one person’s “necessity” is another person’s “needless expense”, isn’t it? But I try not to judge other people’s situations when I can help it.

      I think the most important takeaway is that we all can make different choices if our current ones aren’t working out. Many people don’t realize they have that option.