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High rate vs snowball method

If you have multiple forms of debt, how should you prioritize repayment? This video analyzes two popular strategies for debt repayment to determine which will cost less money over time.

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  • leaf green style avatar for user Gabe
    I don't understand why the High Rate Method is the most mathematically optimal. A $500 debt with 15% APR will incur less interest than $2000 of debt with 10% APR. In the former, you would incur $75 of interest a year; in the latter, you would incur $200 of interest a year even though it has a smaller APR. So wouldn't the optimal way to be pay off the debt balance with the highest interest payment overall after accounting for APR * debt?
    (23 votes)
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  • primosaur ultimate style avatar for user G1S4
    Does it still make sense to be saving during the time you have debt?
    (12 votes)
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  • blobby green style avatar for user knrking
    Did you imply the Snowball works this way? With Snowball, after the credit card is paid, you then have $120 to put toward Loan A each month. After Loan A is paid, you have $195 to put toward Loan B each month. After the first 3 debts are paid, you will be paying $300 a month toward that final Retail Card debt. Psychologically you see not only the individual debts being paid off faster, but feel the difference of making larger and larger snowball payments toward the next debt. Eventually you have that extra $300 of your own money to spend, save, invest as you want every month for as long as you stay debt free!
    (9 votes)
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  • blobby green style avatar for user Mark King
    If he's only paying $20 (by the credit card debt, for example), its still goin up 15% [(500-20)x1.15=552]. The same is by all other debts. So how does he ever pay up his debt, it keeps growing?
    (5 votes)
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    • blobby green style avatar for user LeeWeinstein
      The payments in the example are monthly payments, while the interest rate given is annual. So for the credit card in the example, the annual interest on a $500 balance is 0.15 * $500 = $75, which is less than 12 months of minimum payments, which would be $20 * 12 = $240. That being said, the retail card in the example is strange in that the annual interest on a $4000 balance is $1200, while the minimum payments only total $360, so if you made just the minimum payment, your retail card debt would be ballooning out of control.
      (9 votes)
  • aqualine ultimate style avatar for user Matthias Hunter
    how do I calculate how long it will take to pay off my debts
    (8 votes)
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  • blobby green style avatar for user quinnrhodes91
    how do you solve APR with?
    (4 votes)
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  • blobby green style avatar for user Jay Fan
    Assuming I started all these debts on the same day, (using the high rate method) what would the equation be for me to pay all the debts, plus the $3,904 interest in total in 47 months? I'm confused about the APR, as the APR starts when you're unable to pay off the balance on time and grace periods aren't shown in the video
    (4 votes)
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    • aqualine tree style avatar for user David Alexander
      So, Jay, I watched the video and I'm just going to trust the teacher for the math. I cannot offer you an equation. There are just too many distinct computations. The lesson exists to compare two methods, one of which is more mathematically satisfying, and the other more psychologically satisfying. It shows how the "pyschologically satisfying" method costs you more.

      The grace period on any of these debts is likely to be only a matter of 3 or 4 weeks, so that is negligible.
      Paying off "on time" just means that you make your monthly payments and incur interest on the unpaid balance.
      Don't treat paying of interest with a penalty. Interest, in this case, is "RENT" for the money you have borrowed. In that way, it's like what you have to pay if you rent an apartment (which belongs to someone else) or rent a car (which belongs to someone else). What's going on here is that you are using money that belongs to someone else, and you are paying rent on it.

      When we get all caught up in the idea that debt must be paid off in full before we incur any interest, we are going backwards economically.
      (0 votes)
  • duskpin ultimate style avatar for user C4LOwenZ
    What's a retail card?
    (3 votes)
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    • aqualine tree style avatar for user David Alexander
      You posted this question 10 hours ago. Upon seeing it a few minutes ago, I used a popular search engine and typed "retail card" into the search box. (If your parents allow you to use search engines, you could do this too.) Now, after you've waited at least ten hours, here is what I learned for you:

      "In essence, a store credit card is a credit card offered by a specific retailer that you can only use with that retailer. For example, if you have a Target REDcard, you can only use the card to make purchases in a Target store or at Target.com."

      As good as this course is for you in terms of financial literacy, I think you might also benefit from a course in "search skills". Ask your parents for permission to take one. Then, when you have a simple question like this, you won't have to wait.
      (1 vote)
  • blobby green style avatar for user egoodwinbaxter
    Is it possible to find a way to Use Money in different categories?
    (3 votes)
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  • mr pants orange style avatar for user 30sasaintilma
    I'm kinda confused about the quiz
    (2 votes)
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Video transcript

Let's say that these four items here represent your outstanding debt. So, the first number in each row is the outstanding loan balance. For example, this credit card, you have $500 outstanding balance. The second number is your APR, 15% for the credit card, 30% for the retail card, 10% for this loan, 5% for this loan. And then the last number I have listed here is your minimum payment. So, you have a minimum payment every month. Let's see, 20 plus 30 is 50, plus another 150. You have a minimum payment every month of $200. And your total outstanding loan, your total outstanding loan balance is, let's see. This is 3,500 plus 500 is 4,000 plus 4,000 is 8,000, plus another 2,000 is 10,000. So, you owe $10,000. Your minimum payment is $200. But let's say that you have more than $200 to pay every month. Let's say that you have $300, $300 every month available. So, the question is, what do you do after you pay the minimum payments? What do you do with that extra hundred dollars? As you can imagine, I'm going to tell you that you should use that to pay down your debt so that you can pay it down as fast as possible. But then you might say, "Well, which debt do I pay down first? "Do I just split that $400 four ways "to pay off 25 more than each of these minimum payments? "Do I pay the largest amount first, "the smallest amount first? "Do I pay the highest interest first?" And those are all possible ways of doing it but the mathematically optimal way of doing it is to pay down the highest cost debt first. So, that method is often called the high rate method. Where you want to pay down your highest, your most costly debt first. Which in this case is the retail card. So, the order in which you would pay it is, the order in which you would pay it is-- You would pay all the minimum payments and then any extra money that you would have, you would put it towards the retail card first. Once the retail card is paid off, let's see, after that the credit card has the next highest interest. So, copy and paste. Then, these two loans, they're already in order, 10%, 5%. So, I'm just ordering these form highest interest cost to lowest interest cost. In this world, you would want to, essentially, rank them in this way. You obviously have to pay their minimum payments every month which is $200 but then I would take that extra hundred dollars that you have available and put it to the most costly debt. So, I would put that extra hundred dollars right over here and try to pay this one down as fast as possible. Once that is paid off, then I would put any extra you have after the minimum payments to the credit card. And once that's paid off as well, then to loan A. Once that's paid off, to loan B and hopefully you are then, you might be then debt-free. If you did the high rate method right over here, you would, and you don't incur any new debt, you would be debt-free after 47 months. And you would pay an aggregate interest of approximately 39, $3,904 in interest over those 47 months. So, you say, "Okay, Sal, I get it. "This is the mathematically optimal thing to do "to get rid of your most costly thing first "which makes sense`and then your next costly thing "and then on and on." But you tell me, "Well, you know, psychology matters here. "Psychology, maybe, got me into this debt a little bit. "So, for me, I don't like having my brain always thinking "about all of these four pieces of debt. "So, I would just love to maybe not have to worry "about four things and get to worrying "about three things as soon as possible "and then two things as soon as possible." So, if you think that is helpful, there is a method where you say, "Okay, I'm gonna pay my smallest balance first "to just get that out of the way." Now, keep in mind, if that works for you, if that psychologically allows you to say, "Okay, that hundred dollars "is gonna make a bigger dent here," that's great. That's actually called the snowball method. Let me write here. The idea is a snowball, you get one debt out of the way and then you snowball into the next. But that, just to be clear is not mathematically optimal. It will take you longer to pay your debt and you will pay more interest. But, I'll just write that down because the important thing is that you feel that you should put the hundred dollars to paying down the debt that you don't use it for something else. So, the snowball method would order these things differently. Under the snowball method, you would put your-- Let's see, your credit card has the smallest loan balance. So, let me put that first. So, copy and paste. That's your credit card. Then, after that, let's see, you have loan A. You have loan A here. So, let me copy and paste that. Copy and paste loan A. Then you have loan B. So, loan B. Oh, actually, yup, then you have loan B. Copy and paste. And then you have your retail card. And then you have your retail card. And you could see why this isn't gonna work out well. Why this isn't gonna work out well mathematically 'cause you're leaving your most expensive-- You're paying just the minimum on your most expensive, on your most expensive debt. Not only is it expensive, it's expensive on a large amount. But, let's just go through the... So, you might find it more psychologically easy to do this method because you at least get rid of the credit card debt a lot faster. You'll get down to only three sources of debt versus four much, much faster. So, in this situation, you would pay down the credit card first. So, you'd be able to knock these off faster. But, just so you make sure, there is a trade off. In this one, it's gonna take you 54 months to pay of your debt. So, seven months longer, more than half a year longer. You're going to be making payments. And you're going to pay almost double in interest. You're gonna pay 6,000, approximately $6,000 in interest in this situation versus I guess about 50% more. So, here you're paying almost 4,000 in interest. Here you're paying roughly $6,000 in interest over the 54 months. The mathematically rational one to do would be the high rate method. But this is, you know, whatever it does. Assuming you have the money, as long as you put it down towards your debt, at least you're making progress. And this is a method that some people might want to use more for psychological purposes. I have to admit, I have done this where I just wanted some debt out of the way so I pay down the small one first. But, if you really want to optimize for interest payments and paying down fast, you want to take out your costliest things first.