Debt is one of the few self-inflected wounds you can survive while still being miserable. Debt doesn’t just happen. It’s the result of something: poor decisions with big purchases like homes, lack of emergency preparedness, and lots of small poor decisions come to mind.
Photo by alancleaver2000 via Flickr
Nonetheless, debt is almost always caused by our actions.
- We signed the loan.
- We charged the stuff to the credit card.
- We spent the money elsewhere.
It can be painful to admit our debt was due to our actions, but it truly is empowering when you think of it like that.
How’s that? Because if you got yourself into this mess with your actions, your actions will get you out of it. That’s what we’re going to talk about today.
How to Pay Off Debt
There are multiple methods popular in the media on paying off debt:
- Dave Ramsey’s debt snowball where you pay off the lowest balance debt first, roll the money you were spending on that payment into the next lowest amount, and so on.
- The highest interest rate debt plan, where you pay off the debt with the highest interest rate. (This is the “cheapest” way to get out of debt, at least according to the math.)
- Something in between where you focus on low balance, high interest cards.
Here’s a newsflash for you: it doesn’t matter.
Seriously. The difference between paying off the lowest balance versus the highest interest rate, for most people, will amount to less than $10,000. (And that’s only for people that are way in over their heads in debt.)
Now I’m not saying $10,000 isn’t a lot of money, because it is.
But there’s one thing more important: starting to pay off debt in any way possible. Stop talking tactics and strategies; get to work!
An Example Scenario
Let’s take the Average Family. The Averages have two car loans, a house payment, and some credit card debt. They have enough money to make all of their payments plus $170 extra each month to help knock their debt out faster.
This is what their debt looks like:
- House debt: $158,000 remaining of original $160,000 loan at 4%. Payment of $763.86 plus $120 in insurance taxes.
- Car loan #1: $5,000 remaining of original $12,000 60 month loan at 5.6%. Payment of $229.77.
- Car loan #2: $1,200 remaining of original $6,000 48 month loan at 4.99%. Payment of $138.15.
- Credit card #1: $6,800 balance at interest rate of 19.99%. Minimum payment of $136.
- Credit card #2: $800 balance at interest rate of 3%. Minimum payment of $20.
How do the two methods (debt snowball vs. highest interest rate) pan out?
With the debt snowball method the Averages would pay off their debts in this order:
- Credit card #2, paid off in Month 5, interest cost of $5.29
- Car loan #2, paid off in Month 6, interest cost of $20.42
- Car loan #1, paid off in Month 11, interest cost of $177.10
- Credit card #1, paid off in Month 22, interest cost of $1,927.69.
Total interest paid: $2,130.50.
Not bad, but let’s look at the highest interest rate method next. This is how the debt would be paid off:
- Credit card #1, paid off Month 19, interest cost of $1,414.89
- Car loan #1, paid off Month 19, interest cost of $269.27
- Car loan #2, paid off Month 7 (it naturally pays itself off due to the lower starting balance), interest cost of $24.78
- Credit card #2, paid off Month 20, interest cost of $32.47
Total interest paid: $1,741.41.
Some of you are thinking wow, that’s a savings of $389.09. But let me remind you: over 20 months, that’s less than $20 per month in savings.
So is it important how you pay off your debt? Sure. It does, mathematically, make better sense to pay off the highest interest rate debts first.
But the bottom line is paying off debt in any method is going to save you more interest than not paying off debt. No matter what method you choose, just get going on paying it down.
Your To Do List
- Paying off debt with any methodology is a smart move.
- Paying off debt by paying your highest interest rate debts first is mathematically the best way to get out of debt.
- But paying off debt with the smallest balance first and snowballing forward works almost as well. You’ll pay more in interest, but the psychological perk of knocking out a quick win at the beginning of the process can help motivate you to finish.
- Again, paying down debt in any method at all is much better than just paying your minimum payments.
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.