Well done! You’ve stayed within your budget, avoiding the temptations of internet shopping and nights out on the town. Now you have some cash available and a decision to make: ‘Which debt should I pay down first?’
There are two schools of thought on how to approach this decision. In this article we’ll walk through the pros and cons of both so that you can decide which makes the most sense to you!
Low Balance Strategy
The ‘low balance’ strategy involves paying off debts with the lowest balances first. Let’s look at this strategy’s pros and cons:
- Every debt balance you pay off simplifies your finances, making them easier to manage.
- Paying a 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 the debt pay-off train rolling!
- 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 it’s higher value older brother, the ‘high interest rate’ strategy.
High Interest Rate Strategy
To enact the ‘high interest rate’ strategy, 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…
- 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 still!
- 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.
- 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 compare the two.
Charlie has two loans:
- Charlie is only $1,000 from paying off the 10% interest rate student loan he took in order to go to college.
- 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?
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.
High interest rate strategy
Under the high interest rate strategy, 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
$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!
Which to choose?
As you can see, the strategies lead to different outcomes. The high interest rate strategy is better for long-term financial health if you can stick with it, but the low balance strategy can help build the momentum you need to get rolling.
Whichever strategy you choose, if you have the option to pay down some of your debt balances, congratulations! You’re on the path to financial wellness.