There are two contrasting views of paying off your debt load: to pay the lowest balance first or to pay the highest interest rate debt first. Let’s dissect these two schools of thought and see which is better for your situation.
To start, we need a debt scenario. Let’s take Average American Joe (AAJ). Here is AAJ’s situation:
- His family makes $50,000 per year.
- They spend less than they earn, and after paying the minimums on their debt they have free cash flow of $5,000 per year ($416 per month).
- They have one car loan with a $400 payment. The interest rate is 4.9%, and the balance is $10,000.
- AAJ has student loan debt balance of $25,000 with an interest rate of 6.8%. The payment is $195.
- The couple financed their lifestyle for the last few years, and have $30,000 in credit card debt at a whopping 17% interest. The minimum payment is $600.
In short, AAJ has $416 per month to apply toward paying down his debts. His combined minimum payments are $1,195. His total debt is $65,000.
Which path should AAJ take? Should he go after the lowest balance first (his car loans)? Or should he target that big interest rate on the credit card first?
Pay Off Lowest Balance Debt First
Many people prefer the lowest balance method because it helps you build momentum. You knock out that first debt as quickly as possible and get a “quick win” that makes you feel good about your progress and fuels your motivation toward the next goal.
If AAJ decided to pay off his debts in order of lowest balance first, he would target them in this order:
- Car loans – $10,000
- Student loans – $25,000
- Credit card – $30,000
If he applies his $416 toward the car loan first, he will pay it off in 13 months. He then applies the car payment along with his extra $416 toward the student loans, and pays them off in an additional 26 months. He repeats the process and wipes out the credit card in another 15 months (in the 54th month after he started paying off his debt).
In this situation, AAJ pays a total of $20,573.19 in interest. As you can see, he wipes out the car loans in just over a year and gets his big win. The psychological momentum can be a tremendous boost because you are seeing real results fairly quickly.
Pay Off Highest Interest Rate First
While the lowest balance method helps motivate you to continue, it ends up costing you money. If you target your highest interest rate debt first, you save money because you are knocking down your balance, and thus your interest charged, on the most expensive debt. Maintaining momentum may not be as easy, especially if the balance on the high debt (usually a credit card) is very high. It seems like an eternity that you are fighting against the debt, and it can be easier to lose motivation.
If AAJ decided to pay off his debts in order of highest interest rate first, he would target them in this order:
- Credit card – 17%
- Student loans – 6.8%
- Car loans – 4.9%
If he applies his $416 to the credit card (and stops adding to the balance by cutting up the credit card), he will pay it off in 35 months. (That’s an extra 22 months before paying off the first debt as compared to the lowest balance plan. See how it can be easy to lose motivation?) If he then rolls the $600 minimum payment he has been making with his $416, he pays off the student loans in an additional 15 months. In this scenario the car payment doesn’t even come into the equation because by the time the first two debts are paid, the car loan has been paid off with the regular payments. He is debt free in 50 months, 4 months ahead of the lowest balance first plan.
In this situation, AAJ pays a total of $15,199.32 in interest. That is a reduction of $5,373.87 or 26%. I don’t know about you, but saving over $5,000 just by finding some internal motivation to pay off the highest interest rate debt first seems to make a lot of sense. I could use $5,000+, couldn’t you?
Every Situation is Different
Your personal situation might be different than our example. Maybe your debts are really close together in terms of balance and interest rate. Maybe you don’t have a lot of internal motivation to pay off the debt.
Do what works for you. But be sure to run the math behind what will get you out of debt the fastest. Whatever you decide, remember that even if you ended up paying more in interest… you’re still paying off debt. You’re still working a plan. And that’s what matters most.