Sunday, February 4, 2007

Small Balance or High Rate?

Inspired by War on Credit Cards: Pay Off Smaller Debt or Larger Interest Rate

There's always a big debate on what order you should pay off your debt. The two schools of thought are:

  1. Pay off the cards with the smallest balances for the psychological benefit
  2. Pay off the cards with the highest interest rates for the financial benefit
In my Debt Management 101 class I outline both methods with the pros and cons and then suggest a combo. While I think that you should do the most financially prudent thing, most people need some sort of psychological boost to help them stick to a plan. For this reason, I suggest that if you have 1-2 small debts that can be paid off in 1-2 months then you should do that first. This will give you a great feeling of accomplishment while not costing you much financially. Once you've taken care of the small balance(s) then switch to the financially responsible method which is below.
  1. Make a list of all of your debts and include balance, minimum payment and effective interest rate (this means that for debt which allows interest to be deducted from your taxes you should list the after-deduction rate).
  2. Sort your list by interest rate in order of highest to lowest.
  3. Pay the minimums on all of your debts except for the one with the highest rate.
  4. Pay every extra penny you have towards the highest rate debt.
  5. When that debt is paid off, add the ENTIRE payment to the minimum payment for your next lowest rate debt.
  6. Lather, Rinse, Repeat until debt free.