Which is the Best Order to Pay Off Debts: By Interest Rates or Balance Amounts?

by Julie on July 23, 2014 · 6 comments

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There’s a debate that persists in the personal finance world about the right order in which to pay off debts. Generally speaking, there are two main schools of thought:

  1. Pay off debts off in the order of interest rate (highest to lowest) because it makes the most mathematical sense; you’ll pay the least amount of interest this way. Most financial experts I’ve run across advocate this method.
  1. Pay off debts in the order of the balance left on the debt (lowest to highest) because it makes the most psychological sense; eliminating small debts quickly will keep you motivated. Dave Ramsey, probably the most well-known debt guru, is a strong proponent of this strategy.

So which is the best way? My take: the one that works for you.

And that’s not a cop out answer.

As you read the description of those two strategies above, my guess is that one of them resonated with you more than the other.

While both of them (hopefully) made sense, one of them probably felt the most right in your gut.

That’s the strategy to use.

Seriously, don’t overthink it.

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Personally speaking, we used #2 – the small balance to large balance method – when we were in aggressive debt reduction mode. Like Dave suggests, it was motivating to me to eliminate small debts and save the biggest balances for last when we had freed up more money (the payments on those earlier debts) to throw at them.

Did we pay more in interest that way? Maybe a bit (I never did the calculations). But I know that we paid way less in interest than if we had started a debt payoff plan and then lost our mojo along the way.

Jean Chatzky quote

Still, I get that it would drive some people crazy to be paying off a 2.9% car loan when they have double-digit credit card debt hanging around. Never mind that math; the real issue is that ignoring the interest rates and paying off debt according to balances would keep them up at night. So, for them, the interest rate method is definitely the way to go.

And here’s something else to keep in mind:

You may not be dealing with an either/or situation. At least not much of one.

Once you gather all your information you may find that some of your smallest balances have the highest interest rates anyway. That was our case. There was a little bit of difference in the order of the debts with the two different methods, but not much.

So what’s the best plan? It’s the plan that makes the most sense to you. The plan that keeps you motivated and moving forward. The plan that keeps you excited about paying off debt.

Once you’ve decided on that, get busy throwing money at whatever debt is first on your list and then put your head down and keep going.

The decision to do that is more important than any method or order you choose, based on what some expert or another has to say.

Question: Have you used one of these methods to pay off debt? What’s worked for you?

{ 6 comments… read them below or add one }

Chris July 24, 2014 at 7:58 pm

We definitely follow Dave Ramsey’s plan. It’ s simple and we are seeing results. I guess the three most important principles we have taken to heart are 1). Refuse to take any new debt. 2). Cash flow everything
3). Envelope system works…it’s hard but it works. 4). Keep track of your snowball. We are in our late 40’s and we would like to have some comfort in our 50’s, 60’s, etc…it is now or never!

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Julie July 25, 2014 at 6:19 pm

Chris, I agree with you that part of what make’s DR’s plan so effective is how simple it is. Congrats to you for taking steps toward the future you want. And thanks for the comment!

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The Wallet Doctor July 26, 2014 at 4:09 pm

I think the best path really does depend on the individual. The most important thing is to find something that works that you can reliably utilize. Everything has its pros and cons, but for the individual, some weight more than others.

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Julie July 30, 2014 at 6:39 pm

Totally agree, WD. The most important thing is that you’re paying off debt. Less so is the order in which you do it.

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Michelle July 30, 2014 at 3:54 pm

We follow the Ramsey plan, even though the others make sense. If I knew that I didn’t need a quick pay off and a motivation boost, I would pay off the highest interest. But to keep motivated, I pay off the smallest ones so I can see some progress.

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Julie July 30, 2014 at 6:38 pm

I totally get that, Michelle. It’s so important to stay motivated.

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