A debt dilemma

[vanillabean]

Compound interest is interest added to the principal of a deposit or loan so that the added interest also earns interest from then on. So let’s say you are both sides, having a debt of $2000 whose monthly interest is 1% and $200 per month to put aside for paying down this debt as well as for depositing into an empty savings account whose monthly interest rate is also 1%.

You stick with the same monthly distribution of payments for the two accounts until the debt has been paid off. Which monthly payment amount for the debt is the financially most lucrative? Should it be higher or lower than what you put in the savings account?

The thing is that if you focus exclusively on the debt, you’ll start from scratch on the savings once the debt has been paid off. If you had chosen a high monthly amount for the savings, it would have picked up quite the snowballing head start for earning interest by the end of your debt.

How would you balance the accounts to wind up with the most money down the road?

[SCF]

Mathematically, it almost always makes more sense to pay off your debt first.  The return is gaurenteed, and instant.  Most interest exceeds 1% interest, and most gaurenteed investments in the US right now hover around that 1% interest, so you're hard-pressed to find a better deal.  You may give up several months (or even years) of compounding interest, but ultimately you can invest all the money you save on debt-service and make up that difference.

In your example, strictly by the math, it makes no difference.  Each dollar gives you the same return - but when you factor in the benefits of having a lower debt (greater cash flow, no risk of late payments), I would prioritize the debt and worry about investing second.

[vanillabean]

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@SCF wrote:

In your example, strictly by the math, it makes no difference.  Each dollar gives you the same return.

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Your gut may tell you so, but do you really know?

[heyitsyeh]

Debt compounds too, so it makes no difference which you tackle first in terms of mathematical net worth; only that debt has an end goal (completely paid off) versus investing which has none. So just from a purely psychological perspective I would pay down the debt first for the peace of mind.

[vanillabean]

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@heyitsyeh wrote:

Debt compounds too, so it makes no difference which you tackle first in terms of mathematical net worth;

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You say that, but have you taken into consideration factors such as time and breadth as I described initially?

A compelling argument would be a simple spreadsheet covering loan and savings in parallel moving into the loan paid off and continuing with the savings alone. I did that, and no matter how I configured the monthly distribution, the outcome was always exactly the same.

That doesn’t quite explain why, but it does prove it’s so.

[compassion101]

If contributing to savings and paying down debt were both yielding the same interest, I'd choose the savings. Reason being, things come up in life. Emergencies happen. When they do, you'll be alot better off having money in the bank than less debt. And although we never want to have to do it, debt does have the ability to be cancelled under certain circumstances, wheareas there is no magic button to press to get more savings when your kid needs an organ transplant. 

I'd rather live longer and die with debt rather than live shorter because I didn't have the money to pay for health

[Al209]

As said previously, it makes no difference mathmatically how much you pay towards the debt, as long as you are paying more than the interest being generated and run the time to the same length for all cases.

I wrote a Matlab script to test it and I think it was around 158 months to completely pay down the debt with $25 payments.  Any larger payments will reduce the loan length, allowing you to catch up with the savings.  The only difference the payment makes is how much money you have in savings when the loan is gone.

As a previous poster said, there are benefits to putting some money in savings, so that you can avoid further debt if something comes up.

Since I had a script, I played with the parameters and there is a significant economic benefit to paying down the loan as quickly as possible if interest rate higher than the the savings interest rate.  For the case given, and a loan interest rate of 1.5%, you have around 150 more dollars at the end of the time frame if you pay all of the $200 on the loan until the loan is gone.