I recently inherited $20,000. I know…it is a great problem to have, but I really need some advice for paying off debt! I currently have a $25,000 car loan at a 6.5% interest rate which is costing me $592.87 every month. If I continue these payments through the loan term, I will have paid $3,457.94 in interest. I also have a 48-month, $21,600 line of credit with 0% interest and a payment of $450 per month.
What is the best way to use my inheritance for paying off debt?
Should I pay down the line of credit first or put it towards the car loan? What is the quickest way to be done with both debts?
Great questions! You have probably heard that the best practice is always to put your money toward the highest interest rate debt first. Is that true?
Let’s look at two ways to do this.
1. Paying off Debt with the Highest Interest Rate (Auto Loan) First:
- Pay the full $20,000 towards the auto loan and continue the payment plan as scheduled.
- If you continue to pay $592.87 a month (October payment on the auto loan would be $502.14), your loan would be paid off by October, 2020.
- Total interest paid on the auto loan would be $245.13
- In the meantime, you will have paid $4,050 on your personal line of credit and the balance in November, 2020 would be $17,550.
- Starting in November, add the amount you were paying on the auto loan ($592.87), to your payment on the personal line of credit, increasing it from $450 to $1,042.87.
- It would then take you 17 months (April 2022) to pay off the personal line of credit.
2. Pay Your Personal Line of Credit First:
- Pay the full $20,000 towards the personal line of credit and continue your $450 per month payment plan.
- Your personal line of credit will be paid off by May, 2020 (May 2020 payment on the personal line of credit would be $250) freeing up $450 per month.
- In June, there will be a balance of $22,687.80 on the auto loan and you would have already paid $526.75 in interest.
- Starting in June, increase the payment from $592.87 to $1,042.87 (adding the $450 you were paying on your line of credit).
- Your auto loan will be paid off by May, 2022 and you will have paid an additional $1,536.45 in interest.
- Total interest paid would be $2,062.90
And the winner is…
The best option is paying off debt is tackling the debt with a high-interest rate first. Here’s why:
- You will pay $1,817.77 less
- Both loans will be paid off one month sooner.
This means that what you have heard about always paying the debt with the highest interest rate first is NOT fake news!
Debt Avalanche Strategy for Paying Off Debt
Both examples above utilize a strategy called Debt Avalanche (sometimes called Debt Stacking). Here is how a Debt Avalanche approach works:
- Make a list of your debts in order of interest rate from highest to lowest.
- Continue to make your minimum monthly payment on all of the loans every month.
- All extra money (like your inheritance) should go toward paying off the loan with the highest interest rate.
- Once you’ve paid off that loan, move to the next debt with the highest interest rate adding the amount of the first loan’s monthly payment to the next loan’s minimum payment.
- Keep going until all your debt is paid.
The exception is when your credit cards and/or line of credit debts are rising because the cost of your minimum payments is putting you in a financial vicious circle. In other words, paying your minimum payments leaves you unable to afford the regular costs associated with basic expenses and, in turn, you end up increasing your debt because you are forced to use credit cards or other forms of credit to pay your daily living expenses.
In this situation, you will need to make some decisions. Once you have paid off your auto loan, you will need to decide how much of that monthly amount to add to your line of credit payment and how much to keep in your daily budget. For example, the auto loan you paid off was a $592.87 per month minimum payment. You may decide to add $300 to your line of credit payment (a new monthly payment of $750) and keep $292.87 in the bank if it prevents you from adding additional debts (like charging to a credit card).
Now we know that it almost always makes the best financial sense to pay debts with the highest interest rates first. We also know that it is not easy to do and requires dedication and a lot of willpower. Hopefully the knowledge that, in the end, you will not only be debt-free, but you will have all those dollars you were paying off debt towards your bank account instead! That will be a really good day! #lifechanging