Canadian Finance Blog

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Rational Debt Repayment Posted: 14 Apr 2011 02:00 AM PDT Most people have experience with debt financing and credit purchases. The practice of buying goods and services on credit has been around throughout the history of the dollar, perhaps even earlier. The advantage of debt financing is that you can buy an asset sooner and can thus derive economic value—or pleasure—from it sooner. In today's world, there are many ways to acquire debt financing. Some of them are as simple as using your credit card, while some are a little more complicated, like taking out a mortgage. Because debt is so easily accrued, you might find yourself in a situation where you have taken out many loans for different things and are trying to decide which one to pay up first. If you have extra money, you may decide to speed up the repayment of one of your loans to decrease your debt burden (and perhaps increase your credit score). How do you decide, however, which of your debts to repay first? During my practice, I've repeatedly seen people wanting to repay their smallest loans first. Loans with small face amounts seem easy to get rid of, and you expect that you can then worry about fewer loans in total. It seems reasonable at first – and it makes you feel better, knowing that you have removed an entire liability. It is, however, not necessarily the most efficient or rational approach. Each of your loans has an interest rate: a price you are paying for being allowed to spend the face value. Compare interest to car rental fees. Depending on the make of the car and the company, your rental fees per day/month will vary. Imagine that your plumbing business is renting three different service cars for your handymen. Recently, one of the handymen left and you now only need two cars. The utility of the cars is similar, so you don't care which car you return first. Would you return the smallest car first? Probably not; you would return the car with the highest fee to save the most on rental expenses. Take this approach with your loans as well – do not repay the smallest loan first. Repay the loan with the highest interest rate first and — as counter-intuitive as it may seem — you will have saved more of your money in the end. This may mean that your smallest debts will wait to be repaid last, but with the money you save on interest, you will likely be able to rid yourself of all your loans faster. To be fair, small loans may in fact come with high interest rates, especially when you are borrowing from unregulated private lenders (as opposed to your bank). If the small loan is the most expensive in terms of interest and fees, by all means, repay it first. In general, unsecured loans are more expensive than loans backed with collateral, and loans from reputable institutions, or institutions that know you as a customer, will be cheaper. Therefore, if you have spare money and want to speed up your loan repayment, make sure you know the interest rates (and fees) associated with each of your loans and start eliminating your most expensive loans first. Article was contributed by Lorne Marr, an independent life insurance broker, financial advisor, and an expert on mortgage life insurance and other special life insurance products. Related Posts: How to Get Out of Credit Card Debt Credit Card Debt Relief Options That Work Top Debt Relief Options for Small Businesses Rational Debt Repayment originally appeared on Canadian Finance Blog on April 14, 2011.

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