Once you’ve admitted that your debt is a problem, you can begin to build a plan to correct it. In this post, I will discuss two popular debt repayment strategies. I will compare them and will make a suggestion for which to use.
My List of Debts (Once Again)
Starting off, you will need to make a list of all of your debts. For the sake of this post and for illustration purposes, we will use my actual debt from a few years ago.
Debt Type | Amount Owed | Interest Rate | Minimum Payment |
Credit Card #1 | $6,000 | Variable (~18%) | Varied (~$150) |
Credit Card #2 | $4,000 | Variable (~12%) | Varied (~80) |
Jared Credit | $7,000 | 0% (interest free for 6 months) | $197 |
Student Loan #1 | $3,058 | Variable (2.48%-7.22%) | Varied (~$32) |
Student Loan #2 | $565 | Variable (2.48%-7.22%) | Varied (~$6) |
Student Loan #3 | $1,683 | 6.8% fixed | $20 |
The General Idea
To start off, I will say this: the debt repayment strategies I will discuss involve you paying off your debt. If you’re like me, you’ll have to pay off all $22,000 (plus interest!). Every last dollar and every last penny. These strategies are not schemes where you pay out less than you actually owe.
Back to my story…
When I started my debt repayment, I thought I was being smart. Both of my credit cards were harassing me, and they were the ones that irritated me the most.
Here is my “smart” strategy: Every month, I came up with a complicated mathematical formula to pay down both credit cards.
During the first month of my repayment plan, I had $1,000 to put towards debt. So, I paid the minimums, then paid an extra $300 to Credit Card #1 and an extra $200 to Credit Card #2.
Makes sense, right? I was being equitable to both. I was keeping both relatively happy, right?
Wrong.
There are several debt repayment strategies out there. None of them works as I have described.
Generally speaking, here is how you should pay off your debt.
- Of course, you need to come up with a list of all of your debts.
- Depending on the strategy, you may want to include or exclude your mortgage.
- Next, you’ll prioritize the debts. That is, which one will put your focus on?
- Every month, pay the minimum payments to all of your debts.
- Any extra money you have, pay more to the first debt on your list.
- When you pay off your first debt, you’ll take its minimum payment and any extra money you have, and you pay it on your second debt.
- And so on as you pay off your debts down the list.
I wasn’t doing it right because I was trying to be equitable. I paid my minimums. But all of the extra money I had left over, I split it between two different credit cards. I needed to focus on one (and only one) of them.
Although there are several debt repayment strategies out there, two are extremely popular.
Strategy #1: Pay the Highest Interest Rate First
When it comes debt repayment, pretty much all of them agree on the general method. But they disagree on how to prioritize which debt to pay first.
With Strategy #1, you prioritize based on interest rates. You’ll pay the highest one off first because it makes the most mathematical sense. When you’ve paid all of your debts off, this strategy will save you the most interest.
Strategy #2: Pay the Smallest Balances First
This strategy was popularized by Dave Ramsey and is often called the “Debt Snowball” in the personal finance world. By paying off your debt based on the balances, you gain victories quicker. That is, you will pay off your first debt earlier using this method compared to Strategy #1.
While Strategy #1 focuses on the mathematics behind debt repayment, Strategy #2 focuses on the psychology. By knocking out the first debt quickly, you get motivated and are more likely to continue with the process.
My List of Debts (Re-Prioritized)
Let’s apply these strategies to my own (past) debt. Strategy #1 is to pay off the highest interest rate first. So my list of debts becomes:
Debt Type | Amount Owed | Interest Rate | Minimum Payment |
Jared Credit | $7,000 | 20% | $197 |
Credit Card #1 | $6,000 | 18% | $150 |
Credit Card #2 | $4,000 | 12% | $80 |
Student Loan #3 | $1,683 | 6.8% | $20 |
Student Loan #1 | $565 | 4% | $6 |
Student Loan #2 | $3,058 | 4% | $32 |
Note that I replaced variable rates with fixed ones for simpler calculations. Same for the varied monthly minimum payments. Also, note that the Jared store credit card was 0% for 6 months, but 20% after. I ignored the intro rate for simplicity.
By using Strategy #2, I would place my debts in order of their balances.
Debt Type | Amount Owed | Interest Rate | Minimum Payment |
Student Loan #1 | $565 | 4% | $6 |
Student Loan #3 | $1,683 | 6.8% | $20 |
Student Loan #2 | $3,058 | 4% | $32 |
Credit Card #2 | $4,000 | 12% | $80 |
Credit Card #1 | $6,000 | 18% | $150 |
Jared Credit | $7,000 | 20% | $197 |
Of course, how your debts are ordered are dependent on your personal situation. In my situation, the two strategies prioritize the list almost in reverse order.
But what does this mean? Is one strategy better than the other?
Comparing the Two Strategies
To analyze the two strategies, you will need to know how aggressively you will pay off your debts. That is, how much will you pay above and beyond the minimum payments?
I used an online calculator to come up with the following results based on my debts.
The results are based on paying the minimum payments ($485) plus an additional $970.
Strategy #1 | Strategy #2 | |
Total Interest Paid | $2,016 | $3,015 |
When 1st Debt Will Be Paid Off | Month 7 | Month 1 |
When 2nd Debt Will Be Paid Off | Month 11 | Month 3 |
When 3rd Debt Will Be Paid Off | Month 14 | Month 6 |
When 4th Debt Will Be Paid Off | Month 15 | Month 9 |
When 5th Debt Will Be Paid Off | Month 15 | Month 14 |
When Last Debt Will Be Paid Off | Month 17 | Month 18 |
By paying minimums plus an extra $970, you’ll pay $1,000 more in interest by using Debt Snowball method (Strategy #2).
Overall, the Debt Snowball would take 1 extra month to pay off. But remember that the Debt Snowball’s strength is its ability to provide quick wins.
You’ll pay off your first debt in the first month. That is a very quick victory.
In fact, at Month 7, you will have paid off 3 debts and about 1/3 of your 4th debt using the Debt Snowball. You will have only paid off 1 debt using Strategy #1.
So, Which One is Better?
The answer, really, is “It depends.” I hate when people say that, but it really does depend.
Based on my very specific list of debts, the disadvantage of Strategy #2 (Debt Snowball) is that it will cost me an extra $1,000 in interest and 1 month. Given my overall situation, that’s really not much more money or much more time.
The benefit is that I will have paid off 3 debts in 6 months. That is a HUGE motivating factor, and one that I could not ignore! If I’m looking at a mountain of debt, I would be glad to know that half of them are gone so quickly.
My personal preference is for the Debt Snowball. Dave Ramsey says, and I agree, that your lack of math knowledge got you into debt, so don’t expect it to get you out. Ignore the math, and focus on the psychological boosts.
Final Comments
Remember that if you want to get out of debt, you need to be very intentional about how you do it. Acknowledge that you have debt and that it’s a problem. Build a plan. Pick your strategy. Generally, I like the Debt Snowball. I think it will help motivate you.
Also, remember that you need to be aggressive about how quickly you pay off your debt. In my example, I chose to pay off my debts at 3 times the minimum payment.
If I chose to be lazy about it and just make minimum payments, it would take 5 1/2 years to pay off the debt. I recognized my debt problem in mid-2008. If I paid just minimum payments, I would have just recently paid off all of my debts. That’s a scary thought, given what I’ve gone through in the last 5 1/2 years…