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What debt to pay off first?

which debts to pay first

The debt you pay off first depends on your financial goals. If you want to save on loan fees, then you should pay off debt with the highest interest rates first. But if you want quicker results, you should pay off low balance debt first. 

As of August 2023, U.S. credit card debt surpassed $1 trillion.1 Almost every borrower has some form of debt in their name. But there are steps you can take to decrease your personal debt and achieve financial freedom! 

In this article we’ll walk through the pros and cons of repaying low balances or the highest interest debt first so you can decide which makes the most sense to you!

Low Balance vs. Highest Interest Debt Strategies 

Most people choose between focusing on repaying low balances or the highest interest debt. Take a look at a quick comparison below before learning about the pros and cons of each debt repayment strategy, no matter if you’re dealing with credit card debt or installment loans

FactorLow Balance StrategyHigh Interest Rate Strategy
GoalPay off smallest debts first to reduce the number of debts quickly.Pay off highest interest debt first to save on interest costs.
Interest ImpactPotentially higher overall interest paid due to not prioritizing high-interest debts.Lower overall interest paid by prioritizing the reduction of high-interest debts.
Psychological ImpactHigh, due to the immediate satisfaction of clearing debts.Lower initially, as it takes longer to clear individual debts, but can be high once high-interest debts are paid off.
Risk ManagementLower priority given to the interest rate, which could lead to increased risk if high-interest debts are left to grow.High priority given to interest rates, reducing the risk of debts growing uncontrollably.

Low Balance Strategy

The low balance strategy, also known as the debt snowball method, involves paying off debts with the most insufficient balances first. Let’s look at this strategy’s pros and cons:

Pros

  • Every debt balance you pay off simplifies your finances, making them easier to manage.
  • Paying a fixed or variable-rate loan in full just feels good! It’s like putting down a heavy pack you’ve been carrying for years.
  • Once you feel the satisfaction of paying off a loan, you’ll want to feel it again. You’ll be motivated to keep repaying outstanding debt!

Cons

  • If your lowest balances aren’t your most expensive debts (i.e., they don’t have the highest interest rates), you’ll wind up paying more interest in the long run.
  • Higher-cost loan balances can grow and become overwhelming by the time it’s their turn to get paid off.

Before you put all your money on the ‘low balance’ horse, let’s take a look at its higher value older brother, the ‘high-interest rate’ strategy.

High-Interest Rate Strategy

To enact the ‘high-interest rate’ strategy or debt avalanche method, pay off your highest-cost debts first. The highest-cost debts are those with the highest interest rates. What are this strategy’s pros and cons, you ask…

Pros

  • Paying down your highest interest rate debts will lead to lower monthly interest costs. Interest is charged based on your balance. When the balance comes down, so does the amount of interest you pay.
  • You can use the interest cost savings to pay off other loans, which will lower your interest cost further!
  • Higher interest rate balances grow the fastest. Knocking out the higher-cost loans first lowers the risk of building an overwhelming debt balance in a short period of time.
  • You’ll feel great knowing that you’re conquering the riskiest debt first. Finally, you will tackle your low-interest-rate personal loans.

Cons

  • It will likely take more time to pay off your first loan in full. The wait can be challenging, and your morale might have benefited from a few quick victories.
  • Your financial life can stay complicated for longer. You’ll continue to carry more balances than you would using the ‘low balance’ strategy.

Now that we know the pros and cons of both positions let’s see an example comparing the two.

Charlie’s Choice

Charlie has two loans:

  1. Charlie is only $1,000 from paying off the 10% interest rate student loan he took in order to go to college.
  2. Charlie needed a car for work but didn’t have the cash to pay for it. He borrowed $2,000 to cover the amount he couldn’t afford to pay in cash. The auto loan has a yearly interest rate of 36%.

It’s the end of the year, and Charlie realizes he has $1,000 in cash free to reduce his debt balances. Way to go, Charlie! Now, which strategy should he use?

Charlie Uses the Low Balance Strategy

Under the low balance strategy, Charlie uses his $1,000 to completely pay off his student debt. Charlie leaps with joy at his accomplishment! He knows that soon enough, he’ll be able to pay off his auto loan.

By paying off the student loan, Charlie avoids the 10% interest charge he would have paid on that debt. Yet he’ll still have to pay the 36% interest charge for the auto loan.

Auto loan interest calculation:

36% * $2,000 = $720

Charlie will pay $720 in total interest this year if he uses the low-balance strategy.

Charlie Uses the High-Interest Rate Strategy

Under the debt avalanche method, Charlie uses the $1,000 to pay down some of his auto loan balance. The auto loan’s balance shrinks from $2,000 to $1,000. While Charlie doesn’t feel a major sense of accomplishment just yet, he smiles, knowing that he’s well on his way toward paying off his riskiest debt.

Charlie’s interest costs this year will include 36% on the $1,000 remaining auto loan balance and 10% on the $1,000 student loan.

Auto loan interest calculation:

$1,000 * 36% = $360

Student debt interest calculation:

$1,000 * 10% = $100

Total interest:

$360 + $100 = $460

Using the high-interest strategy, Charlie’s total interest cost for the year is $460, which is $260 less than he would have paid using the low-balance strategy!

The Dangers of Only Making Minimum Monthly Payments

When you are trying to pay down outstanding debt, remember that you should avoid minimum monthly payments. Making only the minimum monthly payment on your credit card can be a deceptive trap that extends the repayment period and increases your interest fees. Paying only the minimum can keep more money in your pocket right now, but you’ll lose more money in the long run and ruin your chances of achieving financial freedom!

Prioritizing the payoff of high-interest credit card debt first and considering debt consolidation can be smarter debt repayment strategies. By increasing your monthly payment even a little bit, you’ll reduce your principal balance faster, save on interest, and improve your credit health! 

Frequently Asked Questions About Debt Repayment 

What’s the impact of only making minimum monthly payments on my credit card?

Making only the minimum payments on your credit card can extend your debt repayment period significantly and result in much higher interest costs over time. It’s a good practice to pay more than the minimum to reduce your high-interest debt faster.

How do minimum payments affect my ability to become debt-free?

Minimum payments can keep you in debt longer because they often cover just the interest and a small portion of the principal. Paying more than the minimum can help you reduce the principal faster and save on interest, moving you closer to being debt-free.

Is it better to consolidate multiple debts into a personal loan?

Consolidating debts with a personal loan can simplify your payments and potentially lower your interest rate. However, it’s essential to compare the personal loan terms and ensure the consolidation truly benefits you in the long run. Accepting the first personal loan offer you get could hurt your finances, so ensure you compare multiple lenders.

How do I decide which debt payoff methods are best for my situation?

Evaluate your debts, considering interest rates, balances, and your personal financial goals. Methods like the debt snowball or debt avalanche can be effective, but the best method is one that you can stick with, and that aligns with your financial priorities.

Can making more than the minimum monthly payment on a personal loan save me money?

Absolutely! Additional payments can reduce the principal balance faster, decrease the total interest paid, and shorten the loan term, saving you money over the life of the loan.

What strategies can I use to manage multiple debts effectively?

You can use strategies like debt stacking (paying off debts with the highest interest rates first) or the snowball method (paying off the smallest debts first for quick wins). Budgeting and cutting expenses can also free up more money for debt repayment.

How can I tackle high-interest debt from credit card payments more efficiently?

Consider transferring the balance to a card with a lower interest rate, if possible. Aim to pay more than the minimum payment each month and reduce unnecessary spending to allocate more funds toward your debt.

Are there any advantages to paying off private student loans before other types of debt?

Private loans often have higher interest rates and less flexible repayment options than federal student loans, so paying them off early can be beneficial. However, compare all your debts to determine which should take priority based on interest rates and terms.

What’s the best way to approach debt repayment to ensure I stay on track to becoming debt-free?

Create a realistic budget that includes debt repayment as a priority. Consider using automated payments above the minimum payment to ensure you consistently pay more than the minimum due on personal loans, credit card debt, and other debts. Stay motivated by tracking your progress and celebrating small victories along the way.

A Note From CreditNinja on Which Debt To Pay Off First 

As you can see, the debt avalanche method and snowball method lead to different outcomes. Paying off high-interest rate debt first is better for long-term financial health, but the snowball method can help build the momentum you need to get rolling.

CreditNinja wants borrowers to have direct answers to their financial questions. In addition to providing online loans, we also provide free financial articles that cover almost every topic. Check out the CreditNinja Dojo for information on the dangers of bad credit loans, finding loans like Mobiloans, calculating compound interest, and more! 

References:

  1. Americans are struggling to pay their debts as economy tightens │ The Hill
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