Debt

What debt should you pay off first?

Dec. 29, 2018

847 words long, 4 minute read

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Trying to pay back debt is hard. When you have more than one line of debt, it can become even more difficult. Between a mortgage, credit cards, and student loans it is easy to become overwhelmed. Prioritizing which debt to pay off first is a key first step towards becoming debt free. Trying to figure out which one to pay back first can be more difficult than it seems on the surface. We will be going through a couple of different methods to pay back more than one debt. There is no "right" way to pay off debt. The important part is that you take the first steps towards becoming debt free.

The two methods we are going to discuss are the snowball method and the interest rate method. Both methods are viable and easy to get started with.

Before you get started

If you want to use this post as a guide, jot down a list of the debts you currently have. The list can be simple, all we need is the following:

  • a name for the debt
  • amount of the debt
  • the interest rate

If you aren't sure where to find your interest rate, look for the APR. This is the annual percentage of interest you pay on your debt. Make sure when you are looking at the interest rate, the rates are on the same time horizon. Most often this is on a yearly basis.

Now that you have your list ready, lets jump into the different methods.

The snowball method

The snowball method (sometimes called the avalanche method) of paying back debt is an idea recently made popular by Dave Ramsey. The idea is that you pay back your smallest balances of debt first. The "snowball" happens as you pay the smallest one, then next smallest, and snow on. At the end you pay off the largest "snowball" of debt. This method doesn't take into consideration anything like interest rates, only the balances.

The psychological benefit of paying off smaller debts first is that it creates a feeling of accomplishment right away. Trying to pay back $110,000 in student loans feels much more daunting than $3,500 in credit cards. Getting the credit cards paid off first can fuel motivation to keep paying off the larger debts. It also helps train your "debt paying muscle" (my term) to train your brain into feeling good about paying debt off.

Let's run through an example. We have a person who has three common types of debt: credit card, a personal loan, and student loans.

Debt Name Amount Interest Rate
Credit Card $5,000 20%
House $175,000 4%
Personal Loan $2,500 8%

In our example the personal loan actually has a lower interest rate (APR) than the credit card debt. However, in this method you don't take anything other than the balance into account and will pay off the personal loan first. Here is the snowball prioritized table:

Priority Debt Name Amount Interest Rate
1 Personal Loan $2,500 8%
2 Credit Card $5,000 20%
3 House $175,000 4%

As you can see the personal loan comes first, then the credit card, then student loans. How fast this person will be able to pay back their debt depends on a bunch of different factors.

Prioritizing by interest rates

Like the snowball method, prioritizing by interest rates is also  straightforward. All you need to know is what the interest rate (APR) is of your debt, and then pay them back in order from highest interest to lowest. If it sounds simple, it is. This method should save you the most in interest costs. Let's run through the same example from above. As a refresher, here are the debts:

Debt Name Amount Interest Rate
Credit Card $5,000 20%
House $175,000 4%
Personal Loan $2,500 8%

And here are the debts prioritized by interest rate:

Priority Debt Name Amount Interest Rate
1 Credit Card $5,000 20%
2 Personal Loan $2,500 8%
3 House $175,000 4%

Unlike the snowball method, we pay off the credit card first. It has the highest interest rate and we want to pay it down as fast as possible.

Which method should I use to pay off my debt?

Like most things in personal finance, the answer to this is it depends. I will try to give the pros, cons, and who the methods might work for to give you a better idea of what might work for you.

Who should use the snowball method

If you find it hard to get motivated or are new to tackling your debt, consider the snowball method. It's popular because it gives a feeling of accomplishment the fastest.

pros

  • easy to stay motivated
  • great for beginners

cons: 

  • over the long term your might pay more in interest
  • can be a longer payback period

Who should prioritize by interest rates

If you have already been actively paying off your debt and want to go faster, try this method. It may not feel as rewarding, but will save you the most in interest over time.

pros:

  • saves the most on interest
  • fastest method of paying debt back

cons:

  • less rewarding
  • can feel daunting if you have a large amount to pay back right away

Finding what is going to work for you is the most important thing. If you have been struggling to take charge of your debt, having a method that you will stick to is more important than anything else. Read our descriptions and try to think about what will work for your personality type. Taking control of your debt is scary, but will be rewarding down the road when you are debt free.

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