One of the most common questions I’m asked by readers concerns the order in which they should start paying off their debts. Usually, they’ll list several debts and then ask me to tell them the order in which they should strive to pay them off.
I usually tell them that it’s not quite that easy.
First of all, they usually haven’t taken basic steps to reduce their debts. Have they consolidated their student loans? Have they done any zero interest rate balance transfers? Have they looked at the option of personal loans? Have they requested interest rate reductions on their credit cards? Those are all steps people should be taking when considering their debt situation.
Secondly, and this is perhaps even more important, there are differing strategies for paying down your debts, each with different benefits, and different strategies work best for different people and different situations. Some people are more geared toward success using one method, while others might be in a debt situation that strongly points them toward a completely different method.
Rather than explaining each of these ideas, I thought I’d show them to you by working through an example.
Let’s say you have five debts:
Debt #1 (credit card) – $5,000, 19.9% interest rate, credit limit of $7,000
Debt #2 (student loan) – $20,000, 7.5% interest rate, no credit limit
Debt #3 (credit card) – $7,000, 24.9% interest rate, credit limit of $15,000
Debt #4 (personal loan) – $2,000, 0% interest rate, no credit limit
Debt #5 (mortgage) – $180,000, 4% interest rate, no credit limit
Ordered by Balance
The first strategy worth discussing is ordering them by balance. This is the strategy popularized by radio host Dave Ramsey and is the basis for his “debt snowball” strategy.
The idea behind this strategy is to order the debts by their current balance, with the lowest balance coming first. Once you have them ordered, you make minimum payments each month on all of the debts but the top one on the list, then you make the biggest possible payment you can toward that top debt.
Using this method, you’re going to reach the payoff point of your lowest balance debt relatively fast, and thus you’re going to enjoy the feeling of success that comes from paying off a debt quite quickly.
That feeling of psychological success from paying off a debt can be a big deal for some people. It can feel genuinely life-changing, as it is proof to many people that they can do this.
If you’re using this methodology, you’d order your debts like this:
Debt #4 (personal loan) – $2,000, 0% interest rate, no credit limit
Debt #1 (credit card) – $5,000, 19.9% interest rate, credit limit of $7,000
Debt #3 (credit card) – $7,000, 24.9% interest rate, credit limit of $15,000
Debt #2 (student loan) – $20,000, 7.5% interest rate, no credit limit
Debt #5 (mortgage) – $180,000, 4% interest rate, no credit limit
Since Debt #4 has such a small balance, you should be able to eliminate it pretty quickly and thus have the success of knocking a debt off your list. You’ll also have more funds available to make a big payment on the next debt.
Ordered by Interest Rate
Another approach to paying off debts is to simply order them by interest rate, from highest to lowest. As with the previous approach, you simply make the minimum payments on all of the debts, but then you make the biggest possible extra payment you can on the top debt on the list.
The logic behind this ordering is that it will mathematically lead to the lowest overall total payments of any approach. In terms of raw dollars and cents, this is the approach that will give you the best results.
So what’s the drawback? Depending on how your debts are structured, sometimes your highest interest debt can have a really large balance and take a long time to pay off. This can make this method feel like a very long slog before you start seeing any success, which can discourage some people.
If you’re using this methodology, you’d order your debts like this:
Debt #3 (credit card) – $7,000, 24.9% interest rate, credit limit of $15,000
Debt #1 (credit card) – $5,000, 19.9% interest rate, credit limit of $7,000
Debt #2 (student loan) – $20,000, 7.5% interest rate, no credit limit
Debt #5 (mortgage) – $180,000, 4% interest rate, no credit limit
Debt #4 (personal loan) – $2,000, 0% interest rate, no credit limit
Ordered by Credit Limit
A third approach is to simply order the debts by how close you happen to be to the credit limit for that debt, typically by percentage. The effect of this is that it pushes credit cards to the top of the list, making you pay them off first, and then the other debts (the ones without a credit limit – in other words, your more traditional debts) come later in an order of your choosing.
Now, why would you take this approach? This approach is best if you’re trying to maximize your credit over the next year or so. If your goal is to have the highest possible credit score six or twelve months from now to improve the chances of getting, say, a home mortgage, you may want to consider this approach.
Why would this help your credit score? One major component of your credit score is your credit utilization, which is the percentage of your overall available credit limit that you happen to be using right now. So, if you have only one credit card with a $10,000 limit and you have an $8,000 balance on it, your credit utilization is 80%. Your credit score drops when that percentage gets high and it recovers when that percentage is low, so if you’re focused on your credit score, you’re going to want to hit those lines of credit directly.
What’s the drawback? For one, you’ll probably want to revisit the list regularly as the percentage of your credit limit used will change regularly on your credit card debts. One month, you might have one debt on top; the next month, another debt might have a higher percentage used.
If you’re using this methodology, you’d order them like this:
Debt #1 (credit card) – $5,000, 19.9% interest rate, credit limit of $7,000
Debt #3 (credit card) – $7,000, 24.9% interest rate, credit limit of $15,000
… and the last three can go in whatever order works for you… here, I used interest rate again.
Debt #2 (student loan) – $20,000, 7.5% interest rate, no credit limit
Debt #5 (mortgage) – $180,000, 4% interest rate, no credit limit
Debt #4 (personal loan) – $2,000, 0% interest rate, no credit limit
Which One Is Best?
So, which one is best for you?
If you have a hard time sticking with goals that don’t show you regular successes, you’re going to want to go with the first method, which is ordering them by balance with the lowest balance first. This will give you your first success the fastest and spread out the successes pretty evenly during your debt payoff journey. For many people, having a quick success can make all the difference in terms of sticking with it.
If you’re focused mostly on recovering your credit score for a potential mortgage or car loan in the relatively near future, order your debts by the percentage of credit limit you’re using and put the ones without a credit limit (i.e., the ones that aren’t a credit card or a line of credit) at the bottom. With this strategy, you’re going to improve your credit utilization as fast as possible, which is a key part of your credit score.
Otherwise, I’d order the debts by interest rate, with the highest interest rate first. This is the method that results in the lowest total amount of interest paid over time, which means more money over the long run that stays in your pocket. This is the method I used for my own debt recovery and it worked like a champ.
Final Thoughts
As with everything in personal finance, there are different solutions that work best for different people. Not everyone is in the same situation. Not everyone has the same psychology. Not everyone has the same obstacles or opportunities.
More than anything, however, financial success comes down not to choosing the best path – although that is useful – but to choosing a positive path and pushing it as hard as you can by cutting personal spending and using that extra money to cut down your debts.
After all, no matter what plan you choose, cutting back significantly on your spending and making bigger extra payments to the top debt on your list is going to do more than having your list perfectly ordered. The list helps, but your good behavior and good day to day choices help even more.
Good luck!
The post In What Order Should I Pay off My Debts? appeared first on The Simple Dollar.
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