Now that you’ve decided to start tackling your debt, the question becomes which debts do you go after first. Do you pay off the credit card balances with the highest interest rates? Or, do you pay off your smallest debts?
It’s different for everyone. There’s no real right answer if it works for you and you continue to pay off your debt. The secret is to simply stick with your plan of attack, continue to pay off debt, and roll your payments into the next balance in a debt snowball, one after another, as you pay off the loan.
Which debt to pay off first is often a heated debate between many financial experts. There are merits to both arguments. Here are a few things about each plan of attack that you should know.
Paying Off Loans With The Highest Interest Rates
Most financial planners and money experts recommend starting to pay off your debts that have the highest interest rates first. This ultimately saves you money on interest charges on your loans.
So, for example, if you had two credit card balances of $2,000 each but one credit card company charged you an 18% annual interest rate and the other charged you only 12% APR, then you would start paying off the credit card balance on the card that was charging you the 18% interest rate.
Eighteen percent interest on a $2,000 balance is roughly $360 per year in interest payments. And 12% is only $240 in annual interest. Repaying the highest interest rate credit card first could save you $120 or more. The savings on interest is what makes this strategy popular with financial planners and experts.
Paying Off The Lowest Balance
Some financial planners and money experts take a different approach to paying off debt. Popular experts like Dave Ramsey recommend paying off your debt by attacking loans with the smallest balances.
So, for example, if you had two credit cards but this time their balances were $1,000 and $2,000, you would pay off the credit card with the lowest balance regardless of the annual interest rate that the card charges you. If in this example, the credit card with a $1,000 balance has an introductory rate of 8% APR and the $2,000 card balance has an interest rate of 22%, you would still pay off the 8% APR card using this method.
Paying off the lowest balance often seems counter-intuitive for many people. Experts consider it a psychological win for people who are struggling to pay off their debt. This method particularly works well when you have several credit cards and other consumer loans with different balances and interest rates that you are trying to repay.
Attacking a smaller balance with extra disposable cash from your monthly budget allows you to get a “quick win”. It gives you a lift and a sense of accomplishment. Then using this method allows you to roll the credit card that you just paid off, its minimum payment, and your extra payments into the next highest balance.
This is the essence of a debt snowball. After you pay off one debt, it rolls into the next and builds. You’re continuing to make the minimum payments on your other debt, but you are focusing on one debt with as much extra income as you can squeeze out of your budget. After that debt is finished, you roll your effort into the next one. Paying off the smallest balance first helps you to start the ball rolling.
Which method of paying off debts do you prefer? Do you like paying off the smallest loan balances first even if they have a low interest rate? Do you really feel a psychological win doing that?