Dear savings Guy,
My Spouse and I have credit card debt from multiple credit cards, student loan debt, and a car payment. What Should I Pay Off First? -Anon
Dear Anon, There’s two primary strategies when it comes to paying off debt. The First is called the “Debt Snowball” Method. The Second, the “Debt Avalanche” method. Lets discuss them both, and then decide the best way you can work to pay off your own debt.
The Debt Snowball Method
The Debt snowball is a method of paying off debt where you focus on the account with the lowest balance, and you allocate all of your available debt repayment money towards that account, paying just the bare minimum on all other accounts. Once this account is paid off, you take the money you were previously paying towards the account, and you allocate it to the account with the next lowest balance. You keep progressing from paying off the account with the lowest balance until you get to the highest balance account. Every time an account is paid off, you’ll have extra money to target paying off the next account. This is why its called the debt snowball. Initially you may only be put a little bit of savings towards paying off your first account, but by the time you get to your last account you’ll have substantially more money to allocate.
The debt snowball method is effective because its mentally satisfying to see your accounts close and will provide you with motivation and encouragement to keep going until all your debts are paid.
While this method is effective, its not the most cost effective method of debt repayment. The debt snowball method focuses simply on paying off the account with the lowest balance, ignoring the interest rates of your various accounts. If you focus on your student loans and car repayments before your credit card debt, you’ll end up paying much more money in the long run due to the much higher interest rate of your credit card balance. This is why I personally prefer the “Debt Avalanche”
Debt Avalanche Method
The debt avalanche is an alternative method of debt repayment where the focus is on paying off the account with the highest interest rate first, paying only the minimum balance on all other accounts, and working your way down the list, paying off the account with the next highest interest rate next, repeating until all of your accounts are paid off.
The benefit to this method is it ensures that you’ll spend the least amount of money possible to pay off your debt. You’ll pay off your debt faster, with more savings left over than using the debt snowball method. The downside to this method is that if your highest interest account is also your largest, it can feel overwhelming to attempt to pay it off. You may get discouraged and give up entirely if you feel like you’re not making any progress.
Which Method Should I Use?
Focus on the interest rate. Its great to combine aspects of the debt snowball effect where you can, but its more important in my opinion to focus on paying off your debt faster so you can start saving for emergencies & retirement.
Start with your Credit Cards. Since you say you have debt on multiple cards, start with the card that has the lowest balance first, pay it off, and work your way up until all of your credit card accounts are paid off. If one of your cards has a 0% introductory APR still, focus on your other credit card bills first.
Next, Take a look at your student loans & car payments. You haven’t told me what the interest rates of these accounts are but take a look at the highest one. A rule of thumb that I like to use is that if the interest rate is above 5 percent, you’re better off paying it off now. If its below 5 percent, you should focus on building up an emergency savings account, followed by an investment/retirement account. You’ll likely get a higher return from the stock market than you’ll get by paying off sub 5% interest rate accounts. If you have federal student loans, or you purchased your car new, you likely have a low interest rate below 5%. If you bought your car used, have poor credit, or took out private student loans, you’re likely better off paying off the accounts. The caveat to that is that some auto loan companies actually charge you more money to pay your loan off faster. Check with your loan company to get your loan payoff amount. If its substantially higher than your current balance, continue making the standard monthly payment. Focus your debt repayment efforts elsewhere.
Check out my article on saving to see where you can save more money to help pay off your debt faster. (https://www.askthesavingsguy.com/2021/09/16/why-youre-broke-hint-its-not-the-avocado-toast/)