Another debt reduction balancing method that I’ve come up with is what I call the “absolute dollar method”. The basic premise of this method is that for every extra dollar that you use to pay down your debt, you should receive at least one dollar of interest savings over the life of the loan. This is a bit more cumbersome than the the debt pricing method I went over in a previous post as it takes some discipline in maintaining a spreadsheet of your debts to quickly assess how much interest savings your extra payments are generating from month to month. This requires updating the spreadsheet every time you make even your regular payments. I can discuss the finer points of creating a spreadsheet like this if you care to comment at the bottom of the post.
I like to use this method when I am paying down debt for a non income producing asset. Sorry, I should have warned you I was about to use financial vocabulary there. (Artists aren’t the only ones that use special words to make themselves feel important!) What this means is that this is a good method for paying down things like credit card debt or other debt used to purchase things where the thing you purchased does not retain its value. A good example is credit card debt or student debt. A bad example is the mortgage on a house.
I make this distinction because the principal from debts related to credit cards or student loans don’t have a tangible material thing to store the value of that paid down extra principal. When you pay an extra dollar towards the principal on your home mortgage, it is a dollar you will eventually get back when you sell the house. This isn’t true for credit card debt. When you pay down an extra dollar in principal on your credit card debt, there is nothing for you to sell later on to recoup that extra dollar of payment. The only return you are getting on that extra dollar of payment is interest savings. Under this scenario, does it make sense to pay an extra dollar to your credit card debt if it is only going to save you 25 cents in interest? (If this sounds good to you, please contact me. I have a lot of quarters I’d like to trade with you)
For a dollar to produce a dollar in interest savings, there has to be enough time remaining on the debt for that extra payment to generate enough interest savings over the remaining term to be equal to the dollar. As time goes on, there is less incentive for you to pay down your debt. This method reflects that by suggesting to not make any extra payments near the end of the life of the debt.
What do you think of this method? Let me know in the comments section!