Psychology vs. Math: The Best Way to Pay Off Your Debt

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Pay Off Your Debt -- Psychology vs. Math

Source: web

Racking up thousands of dollars in debt is a costly decision that is easy to make, but difficult to undo. Swiping your credit card is so simple and seemingly rewarding until the bill comes in the mail. Once those bills start stacking up the real work begins – it might take you one month to get heavily into debt, and years to get out of that debt.

When you finally make the decision to change your finances and sincerely begin paying off debt, you are left with multiple methods to choose from. There are two main camps with debt payoff methods. As with most things in life with two main choices the two different camps point fingers at each other and show why their choice is superior.

Whichever debt payoff method you choose, choosing any method is wise. Paying off debt in any method is better than not paying off debt. Anything you can do to lower how much total interest you pay, pay off your loans, and better your financial is a smart move. While there might be a few benefits to doing things one way or another, as long as you are sending in payments to pay off the debt you are slowly making your financial situation better.

What is the Best Way to Pay Off Debt?

So which way is the best method of debt payoff? Let’s look at the two most popular methods.

The Smallest Debt Snowball

When you are significantly in over your head with debt from multiple creditors, it can be overwhelming to think how to even get started. You’re getting so many different bills in the mail it seems just keeping up with getting your minimum payments mailed off is a success. Of course, paying just the minimum payment on most debts will mean years if not decades of debt.

With this method you line up all of the balances of your various debts – credit cards, car loans, personal loans, and so forth – and simply rank them from smallest debt to the largest. You ignore the interest rate charges on the debts in this method and throw every extra dollar you have at the smallest debt. Once that debt is paid off you take every extra dollar plus the minimum payment you were making on the smallest debt, and you throw that money at the next smallest debt.

The idea is that psychologically you feel a lot better about your progress by getting a win – a paid off debt – quickly. This emotional high from seeing early success motivates you to keep pressing on to pay off the next debt, and then the next after that, until you’re out of debt.

For those who take this path, it works. Early success does help you to continue on with things get tough, and once you get down to your last debt you have a ton of extra money (from paid off debts) that you’re throwing at it.

However, this method is not mathematically the best method to pay off your debt unless all of your debts have the same interest rate. By paying off the smallest balance first you miss out on paying down the balance of the highest interest debt. It’s a trade off – if you need the motivation to keep moving on, it can be worth it to pay a little extra interest.

The Highest Interest Rate Calculation

On the other hand, the mathematical way of paying off your debt is the absolutely best financial method of paying off your debt. The only way to minimize the interest you end up paying on your remaining debt is to pay off the highest interest rate debts first. No other method will minimize your interest paid.

With this method instead of lining up all of your debts by remaining balance, you line them up by interest rate. You then sort the debts from highest interest rate to lowest. With this method it doesn’t matter what the balance remaining is, you just focus on the interest rates. Then all of your extra money goes toward that balance no matter how high it is.

This idea is simple: by paying off the highest interest rate debt first, no matter how large the balance, your minimize your interest payments.

The downside to this method of paying off your debt is it can be a while before you see success. Usually for someone that is severely in debt the highest interest rate debt is going to be credit card debt. And unfortunately, credit card debt is incredibly easy to rack up. If you’ve got a $15,000 credit card balance at 19.99% and only have $200 in extra cash to throw at the balance you’ll be paying on the debt for 3.5 years before paying it off. That is a long time to remain consistent and focused without getting any successes along the way.

How Much Extra Interest From Paying Small Debts First?

If you want to take the snowball method you need to know how much it is going to cost you in extra interest paid. Each situation will be different, but here’s a brief example.

Let’s say your debt looks like this:

  • Student Loan: $25,000 at 6.8% with monthly payment of $287.70
  • Credit Card: $30,000 at 19.99% with minimum payment of $600.00
  • Car Loan: $20,000 at 9.0% with payment of of $415.17
  • Extra payments on debt: $200 per month

If you choose the snowball method, you would pay off the debts in this order: Car loan, Student loan, Credit card. In doing so you would pay $37,165 in interest and be out of debt in about 6 years and 2 months.

Alternatively, if you decided to pay off the highest interest rate debt first you would pay off debts in this order: Credit card, Student loan, Car loan. You would pay $29,674 in interest and be out of debt in 5 years and 9 months. That’s a savings of $7,491 (that’s a 20% savings over the snowball plan) and you get out of debt 5 months faster.

In this example there is a lot of benefit of choosing the mathematical method of paying off your debt. However, your situation may be different. You need to calculate the savings based on your own situation. You can use a site like unbury.me to show the difference between the snowball and mathematical (called “avalanche” on the site) methods.

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About Author

Kevin holds an MBA and has been sharing tips on avoiding debt and earning more income for more than four years on top personal finance websites. He's a big believer in spending less than you earn and tracking your finances through budgeting.


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Advertiser Disclosure

CREDIT DAD is an independent, advertising-supported website. Many debit cards, credit cards and other financial offers that appear here are from companies from which CREDIT DAD Websites receive compensation. This compensation may impact how and where products appear on this website (including, for example, the order in which they appear). CREDIT DAD Websites do not include all card offers in the marketplace.