Debt Stacking

I mentioned debt stacking in my mortgage payoff post, and wanted to give a proper explanation of what it is and how it works.

Put simply, debt stacking is a method for efficiently paying off multiple debts to save both time (term or length of the loans) and money.

Lets say you have 4 sources of debt, for example a credit card, a student loan, a car loan and a mortgage.

	Credit Card	Student Loan	Car Loan	Mortgage	Totals
Principle Balance	$1,200.00	$13,000.00	$20,000.00	$200,000.00	$234,200.00
Rate	16.00%	5.00%	8.00%	6.00%
Monthly Payment	$80.00	$200.00	$500.00	$1,300.00	$2,080.00

Now, looking at the example, we need to sort out the best and cheapest way to pay off our total debt of $234,200.  Instinctively, tackling the credit card debt seems like the first choice.  I would go so far as to say - if you have credit card debt - it needs to be your top priority.  This is due to the way credit card interest is calculated.

With all loans, the 'rate' only tells you half the story.  How the rate is applied to your debt, and how it is used to calculate the actual interest dollars you have to pay on top of your original principle amount, is far more important.

Credit cards use what is called a revolving interest calculation.  That is, the amount of interest dollars you will pay isn't fixed.  This would easily be another lengthy post, but essentially by not paying off your entire statement balance, interest is calculated and added to your principle.  Next month, you pay interest on that new increased balance.

With the other loan types in the example, the interest cost is calculated up front.  It doesn't increase.  So bottom line, the credit card debt needs to go first.  Paying the minimum monthly payment of $80 will never pay off the principle.

Now lets say you trim the fat in your budget, and manage to come up with any extra $100 a month.  You would apply that extra $100 to the credit card payment each month, and continue making the minimum on the other debts.  Eventually, you get the credit card cleared.  Bravo!  Now, you have that extra $100, plus the $80 that was servicing the credit card debt each month.

Surplus		Student Loan	Car Loan	Mortgage	Totals
$180.00	Principle Balance	$13,000.00	$20,000.00	$200,000.00	$233,000.00
	Rate	5.00%	8.00%	6.00%
	Monthly Payment	$200.00	$500.00	$1,300.00	$2,000.00

So we've got $180 to attack our next target.  You might think getting the car loan done next would be best, with it having the highest interest rate.  However, you need to go with the loan that you can payoff the fastest.  $180 on top of the $500 regular payment won't make as big of a difference as putting that $180 on the student loan.  With it's smaller balance, we can get that student loan done much more quickly  Once it's done, now we have $380 extra to put on the next loan.

Surplus		Car Loan	Mortgage	Totals
$380.00	Principle Balance	$20,000.00	$200,000.00	$220,000.00
	Rate	8.00%	6.00%
	Monthly Payment	$500.00	$1,300.00	$1,800.00

Obviously at this point we want to get car loan done first.  Once that is paid off, we'll have a whopping $880 extra for our mortgage payment!

The key point to all this is, without much extra money (or no extra at all) you can systematically attack your debt and have it paid off faster.  This method is quicker than paying a little extra to each loan every month by far. 

In the case of credit card debt - you must get it paid off, whatever it takes.  Sell some stuff on ebay.  Get a part time second job.  Anything!  Otherwise, making the minimum payments, it won't get done.  You'll be under that cloud forever.

Once you do get a debt paid off, you need to be disciplined and apply it to the next one.  Don't blow it!  Keep it rollin'.