How to Pay off Debt: Lowest Balance or Highest Interest First?

When it comes to debt, which is better – paying off the highest interest debts first or the ones with the lowest balance? My answer on how to pay off debt may surprise you.

When I meet with someone as a financial coach, one of the first assignments I give is a debt list. This includes the amount owed, name of the card, company or individual owed and the interest rate.

When people bring their debt list to our first meeting, it would be easy to explain that mathematically it would make the most sense to to pay of the highest interest debts first. Yet this is what I think.

What matters more is what it will take to motivate that individual.

So, instead of telling them what I think they should do, I explain the different ways of paying down debt and the advantages to each. Then I ask them which one they think would work best in their situation.

Occasionally someone will ask me what I would do. If they ask, I tell them. Much like I might ask my Doctor what he would do if faced with the same medical choices I was facing. More often than not, people will find that one suits their personality better. They’ve seen their list. They know the total damage and usually one of the potential ways of paying down debt is more attractive than the others.

Here are some common ways to pay down debt:

1) Highest Interest First

This system makes the most mathematical sense. The faster the highest interest loans are paid down, the more funds there are to apply towards the rest of the debt. My experience is that left brain analytical, logical, linear thinking people generally prefer this method.

2) Pay off the lowest balance first.

Pay off the smallest debt first and work towards the largest debt regardless of interest. This system makes the most psychological sense. It’s very motivating to see the debt paid off quickly. Much like Pavlov’s dog returning to his food dish every time the bell rings, some people are highly motivated by watching their debts disappear. As the lowest balance debts are paid off and crossed out, motivation to continue to pay of the debt increases. My experience has shown that right brained, creative, non-linear thinkers often prefer this method.

3) Debt Consolidation

This might include putting all debts on a line of credit, home equity loan or a 0% credit card transfer. Some people prefer to take all of their debts and consolidate them to one large loan. This is what we did at the beginning of our financial journey.

The risk with this type of debt repayment is that suddenly the person has a pile of credit cards that are free and clear with zero balance. Unless they are willing not use credit at all until the debt is paid down, it has the potential to drive them deeper into debt. This system has the advantage of having a lower interest rate then is generally available on credit cards or department store cards.

Debt consolidation often works well for someone who is committed to get out and stay of of debt and for those who are simply overwhelmed with their lists of debts, minimum payments, due dates and keeping it all straight. It’s the ideal system for for those who feel overwhelmed by their list of debts or for naturally disorganized person.

I’ve heard many a financial writer debate which system they feel is best. Suze Orman argues strongly for the highest interest loans first while Dave Ramsey argues it should be the lowest balance first. In truth, the best system is the one that works for the person who finds themselves with a list of debts they want to pay off.

Which system did you use to get out of debt?

Kathryn works in public relations and training for a non profit. In her off hours, she volunteers as a financial coach helping ordinary Canadians with the basics of money management. Her passions include personal finance and adult education. Kathryn, along with her husband and two children live in Ontario.

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Kathryn

Kathryn has been a staff writer for MDJ since January 2009. During the day she works in an office. In her off hours, she volunteers as a financial coach helping ordinary Canadians with the basics of money management. Kathryn, along with her husband and two children live in Ontario.
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In the hole
9 years ago

Hi. Thanks for your reply. I guess what I am trying to figure out is should I pay the higher balance with the lower interest rate first to try and reduce the rate of the compounding interest because it’s so high or does the higher rate lower balance need the attention first because it’s accruing faster at a higher rate? I guess you have already answered that but I didn’t really understand, I understand the explanation but not sure as to what the answer is. Thanks.

SST
9 years ago

Depends on how you want to think.

Over the span on 10 years (as an example), the interest paid on the $350,000 would be 31% of the original loan; interest paid on the $100,000 would be almost 38%; with a combined interest of near-33%.

However, in dollar terms, on the 6.75% loan, you would be paying almost three times the amount of interest than on the lower rate loan.

In the hole
9 years ago

What should you do (financially thinking) if you have the lower balance has the highest interest? I.e $100,000 @ %6.75 or $350,000 @ 5.65%

Ben - BankAim
9 years ago

My wife and I also consolidated our debt onto a 0% interest card for 12 months. The 3% fee of the amount transferred was much less than the overall interest we would have paid, plus we weren’t getting charge interest every month. This gave us time to ‘catch up’. But as you said, its important to do something with all of those cards with zero balances. We cut all of them up but 1. This kept us from going into debt while we were paying down our other debts.

The question from Jean, if you want to increase your credit score, I believe paying down the debts on the cards with the highest balance would benefit you more. One of the key credit scores looks at ‘how much debt versus how much debt you can have on a card’. If you are over the 30% mark on one credit card, it will eventually lower your score. Meaning, if you have a credit card with a limit of $10,000, you can charge up to $3,000 on the card before it starts to negatively affect your score. This was an issue we had to deal with and saw an improvement to our scores once we paid down our debt.

Matthew Denos
10 years ago

Hi Kathryn,

I think the three options you are offering are brilliant. If you were my financial coach I would find your approach very helpful. These 3 choices allow the indebted person to find what resonates most with them and what suits their personality. I would choose the option of debt consolidation. I am the type of guy who is committed to pay off and stay out of debt.

used tires
11 years ago

My question is this.. if you wan’t to increase you’re credit score, which is best to pay off first?? The highest interest? Or the lowest debt balance? Or does it not matter?

Thanks,

Jean

Kevin
11 years ago

There are more factors involved in debt payback than just interest rate and lowest balance. People forget about the term (how many months left). People forget about the TYPE of interest rate- fixed or variable. People forget about the TYPE of debt- closed end (like a mortgage) or open ended (like a credit card). All of these factors are involved in debt payback. They ALL have to be taken into consideration when deciding which debt gets your extra payment. Don’t just fall victim to “highest interest rate” or “lowest balance.” There is more to this than meets the eye. Think carefully.

Blogging Banks
11 years ago

For me it has always been pay of the highest interest rate first. I disagree on points two, because I find it very likely that the people who do the wrong things, even for motivational purposes have not learned their lesson. Furthermore, by paying off the smallest balance first, the monthly minimum payments won’t drop by much versus paying the highest interest first.

The correct thing to do is step number one. Anything else is irrational and is exactly why we are in a financial mess to begin with!

Marie
11 years ago

Our mortgage is at 6% and carrying PMI but we decided to knock out a 5k student loan at 4.25% to increase our cash flow and accomplish something. Since we still need 22k to ditch the PMI we discovered last month that we hit the number of months of consecutive repayment early with our overpayments on the student loan and they dropped the interest rate.

Therefore there are sometimes benefits within your debt situation to also be considered. We will throw 1500 at the other student loan to knock its interest rate down before eliminating PMI on the mortgage.

Ms Save Money
11 years ago

Phi,

That’s actually very interesting and true – once you’re able to pay off a debt fast it does motivate you more. And even more so when you know your credit score got a big boost from it. Last December my credit score was only at 680 and now it’s at 765 after I got it checked for an auto loan. :)