Today I would like to spend some time answering a reader. Nicole asks, “which debt should I pay off first?” This is a great question and one many of us struggle with as we start to dig ourselves out of debt and feel overwhelmed at the prospect.
The start of my own out-of-debt journey
As I've discussed before, my own journey to rid myself of $40k worth of debt started almost 10 years ago this year. Deep in debt and at a low point in my life – I finally wised up and began the slow 5-year “excavation” process.
My big influences at the time were some very thrifty roommates, supportive family and the book, The Total Money Makeover, by Dave Ramsey (which we have referenced on more than one occasion here).
One of the very first things I did was to make a note of everything that I owed. After that, I created a very simplistic budget in Word so that I could see where my money was going and to give it a place to go. Writing down where your money is going and what you are spending it on is a great first step exercise for those looking to get rid of debt. In my case, it helped me “wake up” to what I was doing with my finances.
The next step was to decide which debt to tackle first.
The two schools of thought on which debt to pay first
I just want to mention the two views on paying down debt and then I'll tell you which worked for me (and I would recommend).
- Smallest balance first. One of the first lessons I learned from Dave Ramsey was that our finances are often tied into our emotions (or the heart) vs. logic (the brain). To deal with our emotional self, Ramsey (and others) recommend paying off your smallest debt first. The idea behind this is to build some confidence and encouragement as you just start out. Crossing off balances on your list will give you an emotional boost that will prove to be invaluable on your journey. After the smallest balance is paid off, you move on to the next smallest and so-on. This is also where you can apply a debt snowball too – where you pay off the smallest balance and then apply what you were paying to that balance to the next smallest, and so on. It's a good way to expedite your debt-payoff (I explain this with more detail in the preceding link).
- The balance with the most interest. This method is the most logical: pay off the debt with the highest interest rate so you won't be paying more money in “stupid tax” (interest) than you have to. Quite simply – you would just jot down all your debts, and then list them by greatest interest rate to the least. And then start knocking off the highest rate debt. This approach can work – and is probably more geared toward those who spend more time in their head than in their heart.
If I had to pick between the two, I would encourage you to start by paying off your smallest balance first. Many of us did not get into debt because we failed to add or subtract wrong but rather, made some poor emotional decisions with our money. This was the case with me. And because of this – appealing to our emotional self is important when we are getting control of our finances again.
What has worked for you in your out-of-debt journey's? Any other advice for Nicole?
I agree, I paid off my smallest balance first. After I paid off the smallest balances I made payment plans for the large balances. It was a lot less overwhelming when I saw the smaller increments taken out of my account. When I would receive a larger sum of money I would put it down on the principal. I’m finally debt free and it’s a great feeling.
I liked this discussion. I actually went the other route on the snowball effect and first attacked my highest credit card and went down from there because as I paid off the ones with highest interest rate and the more I put into the smaller ones and was able to get rid of my credit debt within a year but I did take a very aggressive approach where I had 3 jobs at the same time (remember I got rid of it in a year) so #1 job paid for home stuff, job #2 paid minimum balances on all credit cards, #3 job paid big interest credit card. I never regretted doing that because when that year was up I didn’t have credit card debt and I celebrated Christmas debt free!!
It’s also important to look at the taxes. The interest on your student loans and the interest on your home mortgage are both tax deductible (assuming you itemize). Credit card debt, auto loans, personal loans, etc are not tax deductible. While I agree that the emotional value of getting something paid off quickly is high, the value of being able to write off those expenses is also high and should be considered, in my opinion. You should also consider how all those debts affect your credit worthiness – credit card debt is bad, any balance higher than 50% of your credit limit is very bad. Most loans have a deadline, but credit cards don’t nor are their rates fixed. If you have multiple credit card debts, I would focus on those and use the snowball method on those first – once all of them are paid off then look at the other debt. (I agree, however, that if you have a co-signer on a loan you should get them freed from your obligation as soon as possible.)
It’s logical to pay off the smallest balance first. Once you’ve paid that, you’ll have this feeling of accomplishment and then you’ll see that it won’t be hard to do the next. But I also agree with the rest of them. It’s about your priorities and what works for your best.
@KC – Good point – really important to get the momentum going.
@Becky – Great insight Becky – thanks for pointing this out.
I agree with debtperception: whichever plan a person will stick with is the best plan for them. That said, I do know that Dave Ramsey’s debt snowball works for A LOT of people. I started the year by targeting my debt with the smallest balance; paying it off (a student loan) was a great feeling. I’ve moved on to my debt with the highest monthly payment. This will give me more money to snowball into other payments in the future while also effectively increasing my monthly income by quite a bit once it’s paid off.
Do what works for you. For me, I’m doing a combination of the snowball and highest interest rate. I’m first snowballing my private student loans with a co-signer because getting my co-signer released from my debt is my #1 priority. Once those are out of the way, I’ll start paying more towards the highest interest rate loan.
@debtperception – Yeah, makes sense to do a case-by-case esp. in the case of getting rid of a co-signer
@Ruser – I love the snowball method and is truly a quick way to get rid of debt