What’s the Right Way To Pay Off Your Debt?
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If you have multiple debts at different interest rates, you have a difficult choice in front of you: which debts should you try to pay off first?
There are two big philosophies out there, each with its own advantages and disadvantages.
The first philosophy argues for putting all your extra money towards the your debts with the highest interest rates first. This is called the debt avalanche method, and its main advantage is that it saves you the most money over the long-term. After all, it’s your highest interest rates that are costing you the most, so from a purely mathematical standpoint it makes sense to get rid of them sooner.
The second philosophy argues for putting all your extra money towards your smallest debts first. This is called the debt snowball method and it’s been made especially popular by Dave Ramsey. The argument here is that the motivation provided by paying off those smaller debts encourages you to keep going, and there is research out there that backs it up.
I’m not going to get on a pedestal and preach the virtues of one over the other. The most important thing you can do is find an approach that works for you and stick with it consistently. One way or another, pay off those debts.
But when I’m asked for advice, I like to recommend a hybrid of the two approaches. Here’s how it works.
Step 1: Pay the minimums on everything
This is pretty simple but it needs to be said: before deciding on anything else, you need to make sure that you pay at least the minimum on all of your debts, no matter what.
There are plenty of reasons for this, but the big one is the impact on your credit score. Making all your payments on time is the single biggest factor in your score, and if it ever got so bad that one of your debts was sent to collections, that would be a major knock against you.
Set those minimum payments on auto-pay if you can, but in any case make sure they’re handled before moving on.
Step 2: Find a quick win
If there are any debts you can wipe out within the next 3 months or so, handle those first.
Success provides very real motivation, and I absolutely believe it’s worth finding a quick win out there if you can. That success will show you that it’s possible, and you’ll feel the relief of having one less debt to worry about.
Even a small win can provide all the motivation you need to keep going.
Step 3: Avalanche the rest
Once you get that quick win, or if there isn’t a quick win to be had, I would switch to the debt avalanche approach.
Sort all your debts by interest rate and put all your extra money towards the one with the highest rate. Once that one is paid off, put your extra money towards the next highest interest rate, and so on until they’re all paid off.
The reason is simple: it’s the best financial decision. Paying off your highest-interest debts first will save you the most money over the long-term, and in some cases it may save you thousands of dollars over paying your smaller debts first. That’s a big deal!
With that said, I still like the idea of setting little goals along the way and recognizing when you’ve hit them. You can do something like celebrate every $500 paid off, or you can simply celebrate every month where you make an extra payment. There’s plenty of progress to recognize even if you aren’t paying off a debt in full, and that progress can help you stay motivated to keep going.
Here’s a free tool that will help you do this as easily and efficiently as possible.
Find your own way
This is the way I like to do it. I think it gets the best of both worlds by giving you some quick motivation while still helping you get the best financial outcome. It’s a win-win.
But in the end, the most important thing is that you find a way to pay off your debts that works for you. If you’ve had success with a different approach, let me know in the comments! It’s always fun to learn something new.
I’m a fan of the hybrid approach!!! I think folks to need to look at what got then into debt and analyze what will motivate then the most as they get out of debt. Is it seeing principles fall? Is it getting one debt after another paid off quickly? That helps chart which path is best for them. It’s *personal* finance after all!
Agreed. The most important thing is to find a way to do it that keeps you motivated and on track. Consistency is the key!
Ready for Zero gives a great visual reminder of how much you can actually save in interest by accelerating your debt repayment. I prefer the avalanche method since it’s the most cost effective way of getting rid of debt. For debt that can take years to pay, such as credit card or student loan debt, there can be a difference in the thousands of dollars saved by going with avalanche instead of snowball.
Thanks for the reminder!
Yep, Ready for Zero is a great tool. I especially like how they try to combine the best of both worlds.
It’s always great to give suggestions to readers but at the end of the day, how you ended the post is right – find what works for you. As a blogger, I provide ideas and thoughts on getting out of debt as well, but I make sure to tell people that this isn’t the proven way. It worked for me and it might work for others, but it won’t work for everyone.
The best thing people in debt can do is to read blog posts like this, get some ideas and then pick one that meets their needs/goals or modify it in a way that it makes sense for them.
Couldn’t agree more. Thanks for sharing!
Interesting – combining the benefits of both the snowball and avalanche affects. Definitely worth a try!
I like your hybrid approach. I think it would feed great psychologically to be able to apply the previous minimum payments from a small debt to the avalanche by getting them out of the way first. But I think my hybrid approach would include a savings rate along with debt repayment, depending on the interest rates involved and the risk tolerance of the individual. For us, debt at 0% means that we focus on saving and investing first.
Oh I definitely agree with you there. I didn’t mean to imply that ALL your money should be going to debt. It’s more that this is how I would handle the money that IS going to debt. But I agree with you: if you have low-interest debt I would absolutely think about at least splitting your money between investing and paying off debt. And even if you have high-interest debt I would try to build up a little in savings first. Great points!
I think this is a great approach and makes the most sense. I had been focusing on the debt snowball with our finances, but now that we are to the point where things are starting to look very similar in the amount that we owe I think it may be time to reevaluate!
Good luck! I think especially if the balances are pretty similar, the debt avalanche is probably the way to go. Without the advantage of being able to pay one off sooner, might as well go the route that saves you the most money!
I usually did the debt snowball strategy and it really works well with me. I think, I should try the debt avalanche method and let’s see what would be the result.
Best of luck figuring out the approach that works for you!
I understand the snowballing idea for motivation, but the most commonsense approach to me is to hit the high interest loans first because otherwise you’re paying back more than you need to. Then, as Kirsten said, if you have “found” yourself in debt, think about how you got there so you can tackle the problem before it arises next time.
I can certainly understand why you feel that way, and of course you’re right from a purely mathematical perspective. I think the most important thing is to understand what motivates you and to let that guide you. Consistent progress is the most important thing.
The only other priority to consider is the deductibility of the loan. So even if, god help you, your student (up to a certain income level, then it stops being deductible and drops to the general pool) and mortgage loans, both of which should be the last things you pay down (since, for example, you have a 5% home loan, but since the interest is sliced off your top bracket (let’s say 30% between federal and state) it means that it effectively costs you 3.5%). That is why I paid off my wife’s student loans before even looking at my mortgage (I could no longer deduct so it was in the same category as all other debt).
Great point! While deductible loan interest isn’t automatically better than non-deductible interest, you’re absolutely right that it should factor into the decision when prioritizing one debt over another. Thanks for the great input!