I got into a discussion with a colleague at work about what I should do with my bonus. I told him about all the debt I have, and he told me, “You know what they say. You should pay off the lowest debt first.” This made me think a little as my mom had mentioned the same thing to me when I told her about my student loan debt. With all this money coming in, I will be paying off a lot of my debt and I will need to choose what loan to pay off. Do I pay off the lower amount or the higher interest loan?
I have always believed that paying off the highest interest rate first is the best approach. This way you “lose” less money. I don’t see a problem with making your regular monthly payments and using any extra money to pay off the highest interest rate loan. I just don’t see why you would think paying off the lowest debt first would be the right move. Maybe when you get down to a few hundred dollars, but why not spend that money on the high interest loan so you pay less in interest the next time around. The only advantage I see to paying off the lower debt is the sense of satisfaction that you have one less debt to pay off.
You may have one less debt, but in the long run you are spending more money. $1000 less at 10% interest is $100. $1000 less at 5% is only $50. You put the $1000 into the 5% interest loan, you will spend an extra $100 on the 10% loan. You lose $50 by paying off the lower debt. I would rather keep this $50 and reinvest into the loan. Paying off the higher debt is always a win - win situation. That is why I am using my extra money to pay off my high interest student loans.
There are basically two schools of thought and I think the “right” answer depends on what kind of person you are. Psychologically many people get a lift from getting out of that first debt. That lift can help them carry through with the plan through all their debts. This is more emotional rather than mathematical.
Your idea is mathematically better and the one that I would choose, but it doesn’t give the psychological boost of getting free of that first debt quickly (unless your highest rate also happens to be smallest debt). It does little good if the person gives up after a few months and decides that they can’t get out of debt.
People might be best to build a spreadsheet and total up the debts and interest rates and use the bottom line as their guide of their success rather than the number of loans. If you always do your best to improve that bottom line and see it improving, it should give you the same satisfaction (actually more) as you pay off the highest rate debt.
Of course, you are right.
Paying off the highest interest rate will always save the most money in the long run. All things being equal. You should always pay off the highest interest rate debt first, regardless of the balance, unless you can invest the money at a higher rate of return.
However, you think logically, and do not have a “debt problem” like other people do.
When someone overspends and gets into a situation where their debts are so high that they interfere with their lives, sometimes it can be better to pay off the lower balance first.
By freeing up the minimum monthly payment, more money is available to buy food, pay utilities, etc. In that case, pay off the lower balance.
Also, if someone is a compulsive shopper, and paying off debt also entails decreasing spending, then they can have a psychological need to see results, thereby reinforcing their behavior changes. So paying off the lowest balance first may increase their chances of continuing on a restricted budget until they learn to control the behavior.
A third reason would be if you carry a balance on your credit card and you want to decrease the proportion of balance to limit, in order to improve your credit score. You can take a credit hit if you carry a balance greater than a certain percentage on a credit card, regardless of the balances on other cards. Or so I heard on the radio last week. I have not experienced this firsthand. In that case, you would pay that card down first until it was below the desired proportion, and then switch to the higher APR card.
But in your situation, you are absolutely correct. Pay off the nine percent loan first.
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I posted my own method a few weeks ago, which is a blend of “highest interest” and “lowest debt”, plus a few other factors.
Basically, it’s a blend of highest interest rate along with highest monthly payment amount. This works well for me since all my debts are around the same interest rate. However, some debts are LESS THAN HALF the minimum payments as others.
My wife’s car is 416 a month at almost 6% interest. Her student loan is 6.5% but with a payment of $150.
I want to avert problems if either of us lose our job, so I want to get rid of the highest payment we obliged to make.
It’s a convoluted answer, but it’s working for us and we’ll have one debt paid off in 6 more months (see my debt scales for that)