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.