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High rate vs snowball method

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

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Video Language:
English
Team:
Khan Academy
Duration:
07:14

Vietnamese subtitles

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