Smallest Bill? Or Highest Rate?
The Dollar Stretcher
by Gary Foreman
gary@stretcher.com
My husband and I have accumulated some credit card debt, a personal loan from my mom, and a home equity line of credit. Recently getting married, purchasing our first home, and some medical bills have really put a hurting on our budget. Some advice that I have read says that one should pay off the debt with the highest interest rate first. Other advice says to pay off the smallest debt first and work my way up the debt ladder. Which one is the most effective in our situation?
Amy
According to the Federal Reserve currently there is over $1.7 trillion in consumer debt. So an awful lot of people are facing the very same choice. So let's see if we can figure out what would work best for Amy.
Paying the debt with the highest interest rate will reduce the total debt quicker. The reason is clear. The higher the interest rate, the more interest is added to the balance you owe each month.
Suppose you owed money on two different accounts. The first account charges 5% interest. Paying off $1,000 would save Amy $4.17 per month in interest expense ($1,000 times 0.05 divided by 12 months).
Now suppose the second account charges 10% interest. Paying off $1,000 would save $8.33 per month. Clearly, she'll save more, and reduce her balance quicker, if she pays off the account the highest interest rate.
But, there is a risk to this strategy. It might take Amy quite awhile to pay the entire balance of the account with the highest interest. And, after 6 or 8 months of trying she might get discouraged and be tempted to give up if she's still writing a check to them each month.
Let's face it. Some people are more determined than others. And some of us need immediate feedback or gratification.
One way to get that positive feedback is to have an account disappear because it's be entirely paid off. The fact that it's the account with the smallest balance doesn't matter.
What's best for Amy? Paying off the highest rate of interest first is the most efficient answer. But depending on Amy's personality, paying off the one with the smallest balance might be the best answer.
Before she decides, there are other ways to get positive feedback as you pay down debts. One simple way is to watch your total indebtedness drop each month. Just list the balance on all your accounts and add them up. Then compare the totals after a few months. Notice how the mountain of debt is getting a little smaller. If Amy is into visuals, she could keep a running graph of the total.
Another way to encourage yourself is to watch the amount of interest owed drop each month. Remember that the interest you owe each month doesn't buy you anything. It's the price you pay for borrowing the money some time in the past.
Just list the interest charged by all of your accounts and total it. Again, compare it to the total from a few months ago. If the total amount owed is going down, so should the amount of interest that you pay each month.
Watching her balances drop might not be enough for Amy. She might be one of those people who won't feel successful until she's writing fewer checks each month. If that's the case she should pay off the smallest account first so she feels like she's making progress.
Amy will probably find that her most expensive debt is on credit cards. The least expensive will be her mortgage. If she's sure that they don't have a problem with uncontrolled spending, they might even want to use a home equity loan to pay off some higher interest debt. But only if they're not "spendaholics".
One other strategy would be to pay off one or two of the small accounts to get started. Once Amy is past the point of needing encouragement she can shift to paying more on the accounts with the highest interest.
Finally, it's more important that Amy starts now than which account she pays first. Each month she delays all of the accounts add to the interest owed. The hole gets a little deeper. It's better to pay off low interest debt, than no debt at all.
Gary Foreman is a former financial planner who currently edits The Dollar Stretcher website:
www.stretcher.com
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