Q: How do I determine which debts I should pay off first?
Sincerely, Time 4 Change
$ ?s answered by Matthew Illian, CFP®
Dear Time 4 Change
After pulling your free credit report at annualcreditreport.com, and not from any of the bogus services offering so-called free reports, I have two recommended approaches to paying off your debts. One approach is more analytical and the other behavioral. The first will lead with your mind, and the second will lead with your heart. In either case, stamina and determination will be required to reach financial freedom.
The analytical approach is to sort your debts from highest to lowest by the interest rate you are being charged. When sorting, remember that most mortgage and educational debt interest is tax deductible. This tax savings effectively lowers a 5% tax-deductible rate down to 4%. It is a mathematical fact that you will pay off your debts in the shortest amount of time if you start paying off the debt charging the highest interest rate and pay only the required minimum for everything else.
The behavioral method recognizes that when biking up a mountain, it’s best to warm up your legs on some easy terrain before you attempt the steepest grades. In this method, you should sort your debts from smallest to largest outstanding balance. I appreciate Dave Ramsey’s description of this method as creating a “debt snowball.” This approach recognizes that many get discouraged and give up their commitment to be free of consumer debts when they do not see immediate progress. With the behavioral method, you pay as much as you can towards this smallest balance and only the minimums for all other debts. You should be able to pay off the smallest debt quickly and then transition this payment to the next smallest debt, and so on.
Your success will ultimately be a result of the amount of determination that you bring to this process. In either case, remember to reward yourself at predetermined mile markers. If you are unsure which approach is best for you, go with the behavioral method. Based on a plethora of behavioral finance research of real-life decision making, human beings are less analytical and more emotional than we care to admit.