There are a couple of thoughts on how you should pay off your debt. Should you pay off your debts with the lowest balance or highest interest first?
Do you pay off your credit card and other debt by throwing all of your available resources and free cash flow at the debt with the highest interest rate? Or, do you attack the credit cards or lenders with the lowest balance first?
While many financial planners can argue both rationales, you should know the differences so that you can make the best decision for yourself based on your individual circumstances.
The Benefit Of Paying Off The Highest Interest Rate First
A vast majority of financial experts recommend people paying off the debt with the highest interest rate first. This makes sense when you think about it.
If you had two debts of $10,000 each, one credit card with a 10% annual interest rate (Card A) and a second card that charges you 15% interest (Card B), it will make a lot of financial sense to tackle the debt with the highest interest rate first. In our example, Card A will charge you $1,000 in annual interest over the course of the next year while Card B will cost you $1,500 in interest.
So, if you can pay off Card B first, then you have the potential of saving $500 that you would have spent in interest payments. Those forgone interest payments can be then rolled into quickly paying down the rest of your debt.
The Thought Behind Paying Off Small Balances First
Dave Ramsey is one of the biggest proponents of paying off your smallest debt first regardless of the interest rate that the lender is charging you and saving your largest debt for last.
This is one of the prime components of his debt snowball that he discusses in his book, The Total Money Makeover. His argument is that paying off debt is just as much a mental exercise as it is a physical debt repayment.
You need those easy wins of small loan balances to pump you up and get you excited about rolling those debt payments into new, bigger loans that you need to pay off next. It is quite a satisfying feeling of getting rid of small loans that are like ankle biters that you never have to deal with again.
Pay Off The Lowest Balance Or Highest Interest First
There are a couple of thoughts on how you should pay off your debt. Should you pay off your debts with the lowest balance or highest interest first? Is one plan better than another?
Maybe there is one that is better. But, what you should realize is that the best repayment plan is the one that you stick to and finish. It may not be the plan that saves you the most money in interest payments.
Attacking your highest interest debt will be all for naught if you fall right back into debt immediately afterward or, even worse, if you never complete your debt snowball and stay in debt because you are continuously frustrated with your lack of success paying off your debt. The best debt repayment plan is the one that works for you and your family.