Congratulations! You’ve decided to get proactive about paying down your debt. But where do you begin? That is, how do you decide which loan to pay off first?
It can be hard get better with money until you know exactly what you owe. So start by taking inventory of what you owe. Make a list of your debts, and next to each one write down your monthly minimum payment and the respective interest rate.
Once you’ve got the information on each of your loans laid out in front of you, you can identify which one you’re going to focus on first. Now when we talk about choosing which debt to pay down first, remember, that’s in addition to making the monthly minimum payment on all of your debts. The debt you choose to pay down first is simply the one to which you designate any additional money above and beyond your minimum payments.
Maintaining minimum payments on all of your debts is critical as it can help you avoid late or missed payments and help keep your credit in good health. So if you can afford to pay anything over and above the minimum on your debts, it’s a good idea to do just that. Which brings us back to the question at hand, which loan should you pay off first?
The Debt Snowball Strategy
There are two popular pay-off strategies – the debt snowball and the debt avalanche. Using the debt snowball strategy, you contribute anything above and beyond your monthly minimum payments toward the debt with the lowest balance first. Once that debt is paid off, you don’t reduce the amount you put towards your debt pay-off each month. Instead, you put the total force of your debt repayment efforts towards your remaining minimum payments and the debt with the next lowest balance, gathering momentum as you pay off each small debt.
The Debt Avalanche Strategy
An alternative debt repayment strategy is the debt avalanche. Similar to the snowball method, the debt avalanche method has you pay the minimum on all of your debts each month, but you put anything over and above the minimum toward the debt with the highest interest rate first. Once you’ve eliminated that debt, you focus on the debt with the next highest interest rate, then the next and the next until you get all of your balances down to zero.
Choosing Your Strategy
The key differentiator here is the order in which you pay off your debts. By tackling the debt with the lowest balance first, as you do in the debt snowball, you get the psychological boost of progress and momentum when that smallest debt gets paid off, keeping you motivated through the remainder of the debt repayment process.
The debt avalanche, however, may be the more cost effective strategy because you tackle the debt with the highest interest rate first, and the higher the interest rate, the more expensive the debt is over time. So when you pay off debts with high interest rates first, you could end up saving money in the long run.
While the debt avalanche may be the more cost effective strategy, managing money isn’t always rational. Money can be emotional, psychological and stressful. So you might be more motivated to pay down your debt if you get an early momentum boost by eliminating a small debt early on. The key is to implement the strategy that works best for you. Whichever you choose, keep in mind that consolidating your debt can be a good way to get started.
In the end, as long as you’re making more than the minimum payments on your debts, you’re moving in the right direction. So don’t get stressed out or stuck on picking a strategy. Just pick one, stick to it and you’ll be better off. Every time you send in an on-time payment, every time you pay more than the minimum, every time you take a step towards building your net worth, that’s a win. Celebrate it!