Are you saddled with debt or do you know someone that is? Owing a lot of money can often feel like an anchor that is weighing you down. If you are having debt issues, you are probably searching for the fastest way to eliminate your debts. There has long been a debate over the best method for getting out of debt. The two methods most commonly referred to today are 1) paying off your smaller debts first and 2) paying off the debt with the highest interest rate first. Let’s take a look at both of these methods and see which one makes the most financial sense:
Paying off the smallest debt first
Paying off the smallest debt first is a relatively new strategy that has been gaining steam in recent years. Dave Ramsey is a big advocate of this strategy which he calls the “debt snowball method.” The idea is that you pay off your smallest debt first in order to build momentum. Assume you have 3 credit card bills and the amounts owed are $1,000, $5,000, $10,000. You would pay off the $1,000 debt first then the $5,000 debt and lastly the $10,000 debt. The advantage of this payoff method is that you would feel a sense of accomplishment as you reduce your debts one by one. Paying off a debt is a motivating factor that will push you to pay off the next debt and the next one until you are completely debt free. The disadvantage is that this may not be the best financial decision because you will likely end up paying more money in interest payments.
Paying off the debt with the highest interest rate first
Another strategy that is often discussed is paying off the debt with the highest interest rate first. This strategy is sometimes called the “debt avalanche method” since, like an avalanche, you are starting at the top of the mountain and working your way down. This concept does not give thought to the amount of the debt, but instead focuses solely on the annual percentage rate (APR). CNBC financial host Suze Orman is a strong advocate of this method. Let’s say you had the exact same 3 debts in the example above. The $1,000 debt had an (APR) of 15%, the $5,000 debt had an APR of 18%, and the $10,000 debt had the highest APR of 20%. You would first pay off the $10,000 debt with the 20% interest rate. Next, you would pay the $5,000 debt with the 18% interest rate and finally the $1,000 debt with the 15% rate. The main advantage of this method is that you would actually be saving yourself money by attacking the debt with the highest interest rate first. The primary drawback is that you may not feel as if you are making progress. If the largest debt has the highest interest rate, then the smaller bills will remain until the biggest one is paid off.
So, should you pay off your smallest debt first or the debt with the highest interest rate first? It all depends on how many different consumer debts you have and what the amounts are. If you have 5 different debts with balances all within a thousand or two thousands dollars of each other, then it makes sense to pay off the ones with the highest interest rate, because you’re not tackling one huge debt first. If you’ve got five debts that are something like, $500, $1500, $2000, $3000, and $20000, then go ahead and clean up the smaller debts first to build momentum and to free up more income to throw at the huge debt. Want another key tip on getting out of debt? Don’t forget the most important skill needed to help get out of debt now.
Which method do you think is the best one for getting out of debt?
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