Interest Rates vs. Balances: Which Do You Pay Off First?

If you are trying to get out of debt, there is a lot of discussion as to how you should pay off your debts.  Some experts say it should be paid off by the lowest balance and others say the higher interest rate?  While there is not a “right” way to do it, I will share what we did to get out of debt and the reasons why.

how should I pay off my debt

how should I pay off my debt

First of all, let’s talk about credit cards and why it is not good to carry a balance.  When you owe on your credit cards, your interest keeps compounding and that increases the amount you owe. Here is an analogy for you:

If you have a large fire going and dump a cup of water on it, you will do nothing.  You might make the flames go down for a minute, but they will return.  At this point, you need to figure out a way to really tackle it and get it under control.

However, if you dump a bucket of water on that same fire, you may not put it out completely.  But, you will probably make it smaller.  If you throw two or three more buckets it, you can actually extinguish it.

The same is true with credit card debts.  When you make small, minimum payments you are throwing cups of water on a fire.  However, if you send in a larger amount, you can actually pay it off much more quickly.  But of course, you can’t send in larger amounts to everyone at once, so you have to prioritize.

WHICH DEBT TO PAY OFF FIRST

There is a lot of discussion about paying down higher interest rate cards first or those with a lowered balance first. There is no right or wrong answer, as it will be different each time you talk to another expert.

Both options are listed below.  Read through them carefully to determine which is the right one for you.

FOCUS ON THE HIGHEST INTEREST RATE

Many financial experts will recommend that you list your debts in order of the interest rate, from high to low.  Then, focus on paying on the one at the top of your list first.  They recommend this method as the one with the highest rate is the one which usually will cause you the most financial stress.

Your monthly payment is around 4 – 5% of the balance  That means if you pay the minimum payment, 95% of what you pay is strictly paying interest.

For instance, if your rate on a $1,000 loan is 15% and you pay $40 each month, it will take you 5 1/2 yrs to pay it in full! OUCH!   During that time, you will have paid out more than $360 in interest alone – double OUCH!!  That makes your $1,000 purchase now $1360 (and chances are what you bought has not appreciated in value).

Start by making larger payments on the loan with the highest rate.  Continue making the minimum payments on your other debts.  Once you get the first debt paid in full, roll the amount you were paying on that card to the one with the next highest rate.

The only downside to this method is that it may take you a long time to pay the balance in full.  That might lead you to get discouraged – but don’t let it! If you find that you feel this way, perhaps you should consider paying the lowest balance first, which we explain next.

FOCUS ON THE CARD WITH THE LOWEST BALANCE

We followed this method when paying off off our debts. It was the right answer for us and countless others.  The reason it can work better is realizing faster progress.

To begin, list your debts by the least amount owed down to the greatest.  Toss any additional funds you can at the bill with the lowest balance.  Continue making your regular minimum payments to the other debts on the list.  As you get this each debt paid off, roll those payments to the next one and continue until all debt is eliminated.

You may end up accruing more in interest, but you might be better off psychologically.  When you can see that you are making progress, you will be more likely to continue and not be as quick to quit otherwise.

Paying down debts in this method allows for short-term, attainable goals and that can make all of the difference.

EITHER WAY IS THE RIGHT WAY

Whichever way you decide to tackle those credit cards, it is good that you are doing just that.  While there is no such thing as good debt, credit card debt is the worst debt.  One day you will be able to live a debt free life — and it will be the most amazing feeling in the world!

If you are just getting started trying to get out of debt, catch up with our other steps shared previously on our How To Get Out Of Debt Page.

pay off debts by balance first

pay off debts by balance first

Source: pennypinchinmom.com