- When you have more than one debt, it can be hard to decide which debt to pay off first.
- The maths says you should pay off your highest-interest rate debt first, but psychology says you might be better off starting with the smallest debt.
- In reality, the best method to pay off debt is the one you will stick with throughout your own debt payoff process.
- Visit BusinessInsider.com for more stories.
If you feel like you’re drowning in debt, you are not alone.
Millions of Americans are struggling with crushing student loans, massive credit card balances, car loans, mortgages, and other borrowing. Getting out of debt is easier said than done, but debt freedom is a huge upgrade to your finances.
I paid off a car loan and student loans in my past, and I used the debt avalanche strategy to get the best results. But that doesn’t mean it’s the right choice for you.
Choosing which debt to pay off first starts with two data points for each debt: How much do you owe, and what’s the interest rate?
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Debt snowball: Start with the smallest debt
One of the most popular money personalities in the US is Dave Ramsey. He is known for helping people learn to budget and pay off debt, among other financial goals. When it comes to debt payoffs, Ramsey encourages his readers, listeners, and viewers to follow a strategy known as the debt snowball.
With a debt snowball, you organise your debts in order from smallest to largest. Each month, you make the minimum payment on every debt except for the smallest. For that payment, you should squeeze every possible dollar out of your budget until it is paid off.
As each loan or credit card is paid off, you can use the money you’d been devoting to the previous debt to make a bigger payment on the next-biggest debt, and so on until you are completely debt-free. This strategy works well for many people looking for the winning feeling of seeing success along the way to debt freedom. The psychological factor is huge, and Ramsey says seeing success as you pay off the smaller debts puts wind in your sails to pay off the bigger ones.
Debt avalanche: Start with the most expensive debt
While Ramsey’s strategy makes a good point about starting with a victory, maths says there is a better way to get out of debt. With two finance degrees under my belt, I followed the debt avalanche strategy to pay off my $US40,000 student loans in just two years.
The debt avalanche is similar to the debt snowball in almost every way, but there is one key difference: Instead of paying off loans from smallest to largest balance, you pay off loans from the highest-interest rate to the lowest.
If you plug the numbers into a spreadsheet, you’ll find that paying off your highest-interest rate debt first will save you money and lead to a faster payoff than the debt snowball. To understand why, we have to look at the cost per dollar borrowed.
If you have a loan with a $US1,000 balance and 5% interest rate and a second loan with a $US5,000 balance and 10% interest rate, you are better off focusing on the $US5,000 loan first. Even though some people may feel like it would be easier to just pay off that $US1,000 loan first, the numbers say that’s the wrong approach, and it will cost you more in the long run.
It doesn’t really matter where you start, as long as you do it
While I’m a finance guy who always focuses on the numbers, no two people are exactly alike. Countless people have found success using both strategies. The key is picking a debt payoff order that works well for your finances.
It’s easy to get in a cycle of paying just the minimum each month, but that just leads to bigger expenses and a slower payoff. If you think the debt snowball would work better for your debt situation, use it! You are far better off paying off those expensive loans either way.
Whatever you do, don’t ignore your debt. High credit card debt balances, for example, cost you more through damage to your credit score. Bankruptcy may seem like an easy way out, but it can lead to higher interest rates and denials from lenders.
Turning around a tough personal finance situation isn’t easy. Sometimes debt payoffs require difficult budgeting choices and extra hustle to boost your income. But when you reach the finish line and those monthly payments are gone for good, you won’t regret it.
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