Which Debts to Pay First

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:

Pros

Cons

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…

Pros

Cons

Now that we know the pros and cons of both positions, let’s see an example compare 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?

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


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!

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.