Pay Off Smaller Debts First

[jeffrey]

Courtesy of Wixx and our sister site Debt Reduction 101

You have probably heard the tried and true theory that the quickest way to pay off debt is to pay the highest interest bills first. There does come a time, however, when it is feasible to pay off smaller bills first - particularly certain credit cards with high minimum payments. For example let's suppose that Johnny has been building credit card debt on four separate accounts and now has the following accounts. Leaving aside the option to transfer funds from his higher interest cards to the lowest, for another article when I can devote more time to that particular topic, let us examine the possibility of reducing Johnny's debt.

Account	$ Amount	% interest	min. payment
A	$3000	16%	$60
B	$2000	15%	$40
C	$300	13%	$20
D	$700	15%	$20

Supposing that Johnny has come up with $250 a month to use for debt reduction, it would actually be better for him to pay off credit card C first and then use that extra $20 a month to help pay off card D next. This will have credit cards C and D paid off in 4 months and now he is paying off his highest interest account A with an extra $290 each month. This makes sense only because the C and D accounts have high interest themselves.

If account D was only 10% interest it would not be better to pay it ahead of A or B. The length of time required to pay off the smaller debts is very important as well. If account D had more than just a few months of reduction payments on it, the money would do more work to tackle the large A account first.

Paying off the higher interest rates is the best way pure and simple because you save interest by paying on $250 less the next month, but if you have a few small debts that can be tackled in a few months, and in particular if they have higher minimum payments, paying them off first is a great alternative.

The reason that this can be good is that it gives a sense of accomplishment. We are an instant gratification society, and even though he will save over $1000 in interest by paying off account A first, Johnny does not feel that he is accomplishing anything until he is writing one less check per month. Paying off account C so soon makes Johnny feel good that he is getting his debt under control (and thus will continue to pay down debt and not give up on the strategy). Then when he is working with that extra $20 to use on the accounts with larger dollar values attached to them, his confidence is again boosted.

Adding a car loan to this increases the complexity drastically. Auto loans are typically lower interest than credit cards, but have much higher monthly payments. These higher payments mean that paying this loan off sooner could double the amount of monthly funds that Johnny has available to knock out that credit card debt, but paying that money on the much higher interest credit cards instead reduces the interest paid over the length of the credit card repayment schedule and is the best alternative. Unless your car loan has a high interest rate, it is best to pay that extra money on credit card debt than it is to double up that car payment.

As for mortgages, the overall amount of the loan is so large, and the interest rate should be low enough to make this the final step of the debt reduction process, in my opinion. Once the credit card debt is paid off, the money can then be sent to pay off the mortgage quicker.

[lukkyb22]

fyi, we did this with our tax return. we paid off the car (2800) and i applied my monthly car payment to the student loan. Although tough to stay disciplined, we will be done with the student loan this month after paying more than 400/mo. and i will sleep well at night.

[shan6599]

This looks like a good place to start. I think we'll try it. It was getting frustrating with several loans and getting nowhere.

[Broken Arrow]

The debate over "smallest balance first" versus "high interest first" seems so sticky at times due to so many little variables at play that varies from individual to individual.

One of those variables that I also think is worth considering is how much can one set aside for debt elimination? I've heard that some were so tight on their budget that they believed they had no choice but to pay off the smallest first.

Those who can afford $100 extra a month (at the very least) just for the sole purpose debt reduction may be better served to focus more on high interests first.

[poundwise]

[lukkyb22]

Honestly, I believe the biggest thing is just to start on the debt reduction. Man, as an update, as of today we are totally debt free except our house. So corny--hubby and I clicked the "send payment" button together on the last student loan payment, but what a sense of accomplishment!

[lillyb]

Congrats to you, Lukkyb22!! That is awesome!!

[lukkyb22]

Thanks, Lilly. And I know if we can do it, anyone can!

[The Budget Man]

Originally Posted by Broken Arrow

The debate over "smallest balance first" versus "high interest first" seems so sticky at times due to so many little variables at play that varies from individual to individual.

One of those variables that I also think is worth considering is how much can one set aside for debt elimination? I've heard that some were so tight on their budget that they believed they had no choice but to pay off the smallest first.

Those who can afford $100 extra a month (at the very least) just for the sole purpose debt reduction may be better served to focus more on high interests first.

The three options for debt reduction seem to be:

1/ The traditional idea of debt consolidation at a lower interest rate.

2/ Pay off the highest interest rate debt first.

3/ Pay off the shortest term loan first.

Each of these strategies have good points and bad points. I've been researching and developing software that will do comparisons of these strategies for people. It's early days but a few things are already becoming clear.

All three options have advantages provided you know what you are doing and why.

For fast removal of debt, option 3 where you pay off the smallest loan and then then put the payments against the second smallest loan seems to be the fastest and cheapest option.

Option 2 works almost as quickly depending on the lengths of the loans.

Option 1 where you refinance has the advantage of reducing the overall interest rate. Unfortunately it is very easy to allow short term ebt such as credit card debt to turn into long term debt using this option.

I look forward to in a few months time when it will be easier to look at a situation and give exact options.

I know at one time I nearly ruined my cashflow when I was trying to pay off too many things at once.

Enjoy Your Money
The Budget Man

www.PersonalityBudgeting.com
The budget system that works

[neatdesign]

Originally Posted by lukkyb22

So corny--hubby and I clicked the "send payment" button together on the last student loan payment, but what a sense of accomplishment!

I've been there. When I sent in the check for the last payment for my husband's student loan, I wrote "Good riddance!" in the memo, and wrote the $500 check out so it said, "Five hundred dollars and no sense"!

Hey, they accepted it!!

~ Jenney

[The Budget Man]

I have been talking with a lot of people about debt reduction strategies. It seems that the hardest step is not the first step but the 10th, 11th 12th etc. The challenge is keeping it going.

I find that the only way I will keep going doing something is to make it a routine. That's good, but if I can make it a routine that is automatic I will always succeed.

I put debt reduction on automatic by calling it a bill and having it come out automatically from my bill account. It works for me.

I have most of my bills as routine and never have to worry about them.

Enjoy Your Money
The Budget Man

www.PersonalityBudgeting.com
Automating your budget so it happens

[PRICEPLUS]

Well, I am down to one CC payment so it is a moot point.

[Aleta]

When you set up your plan, you are concentrating on only 1 debt at a time. Meanwhile, you continue to make your minimum payments on the other debts and by the time you get one debt paid off, you see the next one that you will pay off already less because of your payments. We did it and it works, but you have to have a plan. We made a chart where we could see where we were and we were always able to see our goals. We would put stars on them, date them with the pay off date. It is important to get rid of the smaller debts. It's more psychological than anything else. It's important to see something working for you pretty quickly. Then you can take that payment and then add it to the next one and so on and so on. It's a great feeling.

[fairy74]

neatdesign, that is really cute!

I think whatever system motivates someone to work on their debt is what they should be using. At other points in my life, I have used the pay the smallest first just because I was overwhelmed. Now, I have no small debts and just an icky large student loan so that's where I apply all my efforts. Someone else said just getting started is the key and I agree totally

[The Budget Man]

Originally Posted by fairy74

neatdesign, that is really cute!

I think whatever system motivates someone to work on their debt is what they should be using. At other points in my life, I have used the pay the smallest first just because I was overwhelmed. Now, I have no small debts and just an icky large student loan so that's where I apply all my efforts. Someone else said just getting started is the key and I agree totally

It's amazing how important motivation is. For weeks I've been going to trim the fruit trees in the backyard. Then last week the wife told me that she had seen the first fruit flies of the season. All of a sudden I had to trim the trees so she could protect the fruit. (Once the fruit is fly struck it is useless)

I act when I have motivation.

It's the same with debt and budgeting. If there is no motivation to get rid of debt then the debt grows.
The Budget Man

Discover how to be motivated with your budget
www.PersonalityBudgeting.com

[loanstar]

i think this method is good for one reason; phycologically, you feel like you're making progress.
Otherwise, if you have the descipline, there's no reason why the old 'highest interest first' wouldn't work for you!

[Aleta]

The one reason in getting rid of the smaller debtf first is as fairy76 said above. When you have alot of different debts and feeling overwhelmed; getting rid of a few smaller debts eases the load. You have got to consider the time, envelopes, postage, and general keeping track of more debt. It gives you a feeling that you can do it and getting somewhere. Some people need the visuals to motivate them. Another factor is that the monthly payment on even one of the smaller debts could be a high one and you could get rid of it faster as to use the money on the next debts.

[momo2winz]

We almost did it yesterday. Almost gave the Turning Debt Into Wealth company 12,000.00 for a year of coaching. They hinted at the concept, pay of smaller debts first, roll the payment we were making in to the next debt. We asked for 24 hours to sleep on it, did some googling and found this site! Jeffrey's page on exactly this concept motivated me to restructure my excel spreadsheet, to lower all my card payments to the minimum and to pay off my smallest card balance. I will now take my old payment that I was making on that card and roll it into the next card balance added to the old payment I was making on that card (always made higher than min. pmts). I will have that card paid off in 2 months. By loweing the payments on the cards that are not yet in line to get paid off I loosened up my rent payment for my business so I will no longer go into overdraft when my rent check hits the bank (at 26% for cash advance!). I am so excited to have found this site and am sure I will get the support and mentoring I need just from reading the blogs! Anyone have suggestions for me? Is this the right thread to stay connected to? Thanks Jeffrey!

[Aleta]

momo2winz: Welcome. I think alot of us came to this website looking for alot of answers. You sound like you're off to a good start. Keep reading. There's alot of information here that can help you.

[cptacek]

Originally Posted by momo2winz

We almost did it yesterday. Almost gave the Turning Debt Into Wealth company 12,000.00 for a year of coaching.

Holy crapolly!!! Good decision to sleep on it!!!

You will hear both arguments here: "pay off lowest amount first" or "pay off highest interest rate first"...but the key concept is "pay it off!!!" Look at some back threads and ask questions...and welcome.