We’ve all been there.
Student loans to help pay for tuition.
Overusing your credit cards to pay for expensive Christmas gifts, vacations you couldn’t afford to pay cash, or overspending in general.
When I started my post-doc (more years ago than I like to think), I had just moved to the US and borrowed $6000 at 10.4% (!) to buy a used car. Paying nearly $200 per month wasn’t easy on a $31,000 salary. Especially when that salary also needed to pay the rent and put food for four on the table.
I know the financial and psychological toll of owing money.
If you too struggle with too much debt, what’s the best way to pay it all off?
It turns out there are two “best ways” to do it, and your personality determines which one is right for you.
Think of money like a river, with interest like a current you have to overcome. To pay off debt, you have to paddle against that current. If you don’t paddle fast enough, the current will carry you further and further downstream. In financial terms, if you pay less than the interest on what you owe, you fall deeper and deeper into debt.
There really are two best strategies for paying off your debt.
- The most financially efficient: Pay the minimum on all your debts except the one with the highest interest rate. That highest-interest debt is your “target debt” until it’s paid off, so pay as much extra as you can to kill it off as quickly as you can. Once that target is paid off, add the amount you’ve been paying against it to the next-highest-interest debt, which is your next target debt. Once that one is also paid off, keep moving down the list to the next-highest-interest debt until you’ve paid off all your debts.
- The easiest to stick with psychologically: Pay the minimum on all your debts except the one with the lowest balance, which is your first target debt. Pay as much more as you can on that one until it’s paid off. Then, add what you’ve been paying against that debt to your next target debt, which is the next-lowest-balance debt. Keep moving down the list, tackling larger and larger balances until you’ve paid off all your debts.
If you read carefully, you noticed the two strategies are very similar. Each time you retire your current “target debt,” you add what you paid against it to your next target.
The difference is the order of picking those targets. With the first method, you target debts in order of high interest rate. In the second, you start with the lowest-balance debt and work your way up the chain of dominoes.
In both cases, as you retire more debts, you pay ever-growing amounts against your next target debt, retiring those ever more quickly.
The first method is like the kayaker choosing to fight the strongest current first, knowing it’ll get progressively easier after that. In financial terms, the quicker you pay off higher-interest debts, the less time those debts incur their higher cost.
The second method is like our kayaker working on the easiest current first. This lets him build up his paddling skill and endurance, making it easier to tackle stronger currents later.
If you were a robot or computer, the first strategy would always win. However, most people find the second strategy easier to stick with. Behavioral finance research shows you’re more likely to keep up with a difficult program if you experience early success.
To choose which method is best for you, ask yourself, “Am I disciplined enough to stay the course even if I don’t see the evidence of success (retiring a debt) early, or am I more likely to stick with it if I have such an early success?”
If you feel disciplined enough to stick with the harder rowing, choose the first method, targeting the highest-interest debt first. This will minimize your overall interest cost.
However, if you’re not sure of your discipline, target the lowest-balance debt first. That’s because it’s worth paying a bit more interest if it keeps you paddling until you reach your target.
So, which method is right for you?
Opher Ganel has set up several successful small businesses, including a consulting practice supporting NASA and government contractors. His most recent venture is a financial strategy service for professionals, especially mental health providers.
This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.
Originally published at https://www.wealthtender.