Okay, so you’ve gotten yourself into a bit of debt. It’s okay. This is a no-judgement zone. We’ve all done it. It’s what you do now that will make all the difference.
You need to decide which debt to pay off first.
There are basically two schools of thought on this. One is to payoff the smallest balance first and then add the amount of those payments to your remaining debt. Repeat the process over and over until all of your debt is gone. It is the so-called Snowball Method.
The other approach is to payoff the debt with the highest interest rate first, even if that means carrying balances on multiple accounts for longer.
I know that there is a lot of support for the first method… it feels good to get an account down to a zero balance. But, it is a more expensive way to clear debt than tackling higher interest rates first.
Payoff High Interest Debt First
Let’s look at a simple example. Imagine you have two credit cards. One has an interest rate of 25% and a balance of $1,500. The other has an interest rate of 5% and a balance of $500.
Now, imagine that one month, after paying all your bills, you find that you have an extra $100. You decide you are going to put that $100 toward paying down your debt. But, which card should you put it on?
If you put it toward the smaller balance you might be able to pay that card off completely in just a few months and that will feel good! But, this is not a blog about feeling good about yourself. It is a blog about sound financial advice.
To figure out where your money will do the most good, you need to know how much each $100 you have borrowed is costing you. Then, you should stop borrowing (pay back) the most expensive $100.
The good news is that it’s super easy: Every bank that lends money is required to put your interest rate right on your statement every month. So you can just look at your statements and multiply the interest rate on each of your balances by $100. That’s how much a hundred dollars on that account costs you per year.
In our example, $100 on the blue card costs you $25 per year. And, $100 on the green card only costs $5 per year.
I don’t know about you, but it seems pretty straightforward to me: If I have the option of paying $5 for something or $25 for the exact same thing… I will choose $5 every time.
That’s why I would choose to pay off the more expensive debt first. I would put the extra $100 payment on the blue card.
The best part: this works for all kinds of debt.
You can compare your mortgage, car loan, student loans, credit cards, personal loans, payday loans, furniture store loans… everything.
Every lender in the US is required to disclose the interest rate on every loan they issue. And, they are all required to calculate it the same way. So, you can decide exactly how to distribute your hard-earned money to repay the loans that are the most expensive first.
One quick clarification: this applies to extra payments you are making beyond the minimum payment.
Be sure that you are making the minimum payment on all of the debts you have: credit cards, personal loans, car loans, mortgages, etc.
Then, when you have the ability to make additional payments, choose the loan that has the highest interest rate first. Pay that loan off in full before you make any additional payments (beyond the minimum) to any of your additional loans.
For most people, this will mean paying off unsecured debt first because that debt generally has higher interest rates. So, the waterfall will likely look something like:
- High-interest credit cards
- Lower-interest credit cards
- Personal Loans
- Car loans
- Student Loans
Of course, the order may be different for you. It all depends on your interest rates.
If you need help deciding between paying down debt and building an emergency reserve, check out my take on the Cash Windfall Waterfall.
If you find that you never have any extra cash flow for additional debt payments because you are living paycheck-to-paycheck, I go into detail on how to break that cycle in my book: Practically Independent: Practical Advice to Become Financially Independent.
I hope this helps! Comment below with your tips and tricks – or send me an email any time!