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 continually 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.
This question has plagued financial planners for years. Should you pay off debt, or should they start a retirement account first? This assumes that the same amount of money is involved in each transaction. We will use $5,000 for our examples. Below we will take a look at the pros and cons of each option, and give our opinion.
Paying Off Debt First
Paying off debt is a great way to use a lump sum of money. Being in debt can be burdensome to the individual in debt, and feeling like you are never going to get out can be awful. If you do not have a lump sum, you may want to consider a debt management plan to help you. But, if you were going to use a lump sum of money to pay off debt, here is what it would get you.
Pros: Peace of mind, lower payments or elimination of payments if the debt is paid off, ownership if the debt is backed by something (i.e. a car loan).
Cons: You tie up your money into whatever your debt is.
Start a Retirement Account
Starting a retirement account is a great way to save for the future. Plus, since we’re talking about a $5,000 investment, that happens to be exactly how much the limit is for contributions to an IRA. Now, Congress has raised the limit, and you can invest up to $5,500 in 2013 and beyond in an IRA or $6,500 per year if you are over the age of 50.
IRA rates are great when you pick good mutual funds to invest in. There are a lot of different types of retirement accounts available, but we are going to focus on opening a Roth IRA.
Pros: Saving for the future, money grows tax-free, can withdraw contributions tax-free any time.
Cons: Can’t withdraw earnings tax or penalty-free until retirement age.
The Trade Off
As you can see, both options don’t have too many cons. However, when making this decision, you should weigh the following: which will earn me a better return on my money?
If your debt has a high-interest rate such as 19.99%, for example, it is highly unlikely that you will earn that return in a retirement account. So, paying off your debt could be a great use of your excess funds.
However, if your debt is at really low-interest rates, say a 4% student loan, which you also can write off on your taxes (making the effective rate around 3%), a retirement account where you can earn 8% may be a better option.