There's some debate among financial planners as to the best way to pay down debt. Some say paying the highest interest rate debt first is the best way; others say paying the smallest balance first is the best way.
Both methods have advantages and disadvantages, so we'll take a look at both, and help you decide which method is best for you.
Method #1 - Highest Interest Rate
In this method, you focus on paying off your highest interest rate debts first. The basic steps in this method include:
1. List all debts in order from the highest interest rate to the lowest interest rate. 2. Commit to paying the minimum payment on every debt. 3. Determine how much extra can be applied to the highest interest rate debt. 4. Pay the minimum amount plus the extra amount towards the debt with the highest interest rate until it is paid off. 5. When that debt is paid off, apply the amount you were paying to the debt that is paid off to the next highest interest rate debt until paid off. 6. Repeat until all debts are paid in full.
This method is the best method mathematically, as you will pay less interest in the long run.
Method #2 - Lowest Balance
In this method, your focus is on the debt with the lowest balance. Note: this method was made popular by Dave Ramsey and is often called the Debt Snowball method.
The basic steps in this method include:
1. List all debts in order from the smallest balance to the largest balance. 2. Commit to paying the minimum payment on every debt. 3. Determine how much extra can be applied to the smallest balance debt. 4. Pay the minimum amount plus the extra amount towards the debt with the smallest balance until it is paid off. 5. When that debt is paid off, apply the amount you were paying to the debt that is paid off to the next smallest balance debt until paid off. 6. Repeat until all debts are paid in full.
This method may not be the best method mathematically, as you will pay more interest in the long run. However, this method allows you to pay smaller debts off faster, which may give you the motivation you need to stick to your debt payment plan.
So, which method is best for you? It depends…
Method #1 is best for you if:
* You have debts with similar balances * You have discipline to stick to your debt repayment plan * You are a numbers person, and you realize the benefit of paying off the highest interest rate debt first
Method #2 may be best for you if:
* Your debts do not have similar balances - i.e., you have a $500 credit card balance, a $12,000 credit card balance, and several in between * You need motivation - paying off the smallest credit card balance may be the motivation you need to stick to your debt repayment plan * You don't mind paying more interest over the long run in exchange for getting rid of smaller balances first
Tip: Why not use a combination of the two methods? Using a combination of both methods allows you to feel a sense of accomplishment by paying off that first debt (the smallest balance credit card), and gives you the motivation to start working on the next debt (the debt with the highest interest rate).
Remember, the method that works best for you is the one you will actually use. The most important thing is to make a plan and stick to it so you can live debt free.
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Kristine A. McKinley, CFP, CPA, and founder of Beacon Financial Advisors, teaches individuals and families how to invest and plan for retirement, college, and other financial goals. Kristine offers financial and tax planning on an hourly, fee-only basis. Did you find this article helpful? If so, then be sure to check out our new ebook, Living Debt Free! => http://beaconfinancialtips.com/
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