Mathematically, it’s obvious that paying off loans with the highest interests rate first makes the most financial sense but as you may know, some financial experts promote “paying off the smallest loans first”. Why do they do that? Let’s take a look today.
Smallest Loan First
The smallest loans first method is simple. Instead of paying off debt with the highest interest rates (ie, the ones with the least favorable terms), you put that aside and list out all your debt sorted by the amount owed. Then, you pay the minimum payment of all your loans each month and pile all other available income for debt repayment into the loan with the smallest amount outstanding. Once the first debt is repaid, you try to repay the second smallest debt you owe and so on.
The argument is that eliminating bills are so satisfying that it will keep you on track with the overall debt repayment plan. The positive and quick feedback will have a great impact on your commitment to repaying your debt and will overcome the increase in interests that you need to pay.
Highest Interest Rates First
With this method, sort your debt by interest rates and try to pay off loans with the highest interest rates first while paying the minimum payment with all the other loans. Once one loan is paid in full, move on to the next down the list.
The facts are undeniable. Paying off highest rates first saves you the most total interests. In turn, it helps you pay off your debt the quickest because more of your hard earned money is going towards principal reduction.
Which Debt Snowball Method is Better?
While the math isn’t in your favor, I believe the smallest loan first method is better for most of us. Being able to eliminate one of your debt payments is huge and for most people, positive feedback is not only helpful but necessary. Without periodic encouragement, it’s very difficult to be disciplined enough to pay off all our debt.
I know that if I’m encouraged, I am more willing to do more. Therefore, being able to cross off debts may prompt me to save more, thereby allowing me to put even more towards my debts.
Sure the math doesn’t make sense, but Algebra (or is it Calculus?) in school never did either.
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{ 12 comments… read them below or add one }
I have read Money Makeover and for me it is easier to pay off the lowest loans first. Being able to see what you have done is better then only paying for the highest loans. Making a chart for my debt payments has helped me. I like seeing what I have done and knowing that financial freedom is on the way.
W. Jackson
I really struggle with this one, since my mathematical mind tends to always win the argument. I understand the psychological benefits of paying off small loans and if it’s a choice between paying off small loans first and just making minimum payments, clearly paying off is better. If the goal is to get out of debt completely, then doing so as quickly (and inexpensively) as possible is the way to go. If you can become disciplined enough to pay more than the minimum on any loan, I believe that you can do the smartest thing and pay the highest interest ones first. Track the money you’re saving (or how much faster your debt is going away) by paying the highest interest loan first and you’ll have all the motivation you need.
In the past I did a combination of the two. Knowing that it was cheaper in the long run, I’d try to pay the highest interest one off first. But… if there was one that was closer to being paid off, I’d jump on that one first. Say I’d had 6 things to pay off – I’d keep on the highest interest one, but also pay attention to the closest one to pay off and put extra on it.
There was not just a psychological boost in getting that lower one paid off – there was a cash flow boost…. the money from not having to pay that little one anymore could go toward the big one. Plus, in lower income times, it was just making things easier on the cash flow needed each month. Therefore, my way was a seesaw back and forth. Worked for me – debt free and intending to stay that way
There is always debate about this type of issue, and here really is no best way to go about it, as long as the debt is being paid down.
My personal viewpoint would be to keep additional interest from compaounding, so the highest interest rate is what I would target first and put most of my resourses toward. Some people may feel that if they can erase a small debt completely even though they will incur more interest from other labilities that it will help them psychologically, and that’s fine too. However, they will be staying in debt longer with that type of mentality, but if it happens to help people sleep at night, then I could not fault them.
I wrote about something similar that perhaps will better explain my view called
I like the smallest loan first method as well because it frees up a little more cash quicker to work into the snowball. It also really does help psychologically to get something taken care of.
Paying down the smaller amount actually gives you momentum and that sense of achievement so you are more motivated to keep going and pay off the rest.
I like the momentum gained by paying the smallest loans first, but I also like the idea of eliminating several accounts quickly in case you run into a financial crisis. If I were to be laid off from my job, I probably wouldn’t be able to keep all my accounts current. I’d rather have to deal with calls from 7 companies instead of 14. Even if I never get laid off, I’d like to simplify things as soon as possible. Keeping track of fewer debts is easier and can reduce stress.
I have always operated this way…smallest to largest. Getting those early wins builds momentum.
I posted on this topic a while back, and essentially I think you need to do whatever works best for you. Dave Ramsey himself even says that ” you can’t go wrong getting out of debt”. So just start doing it one way or the other, and get out of debt.
For me, I will choose highest interest rates first. My main focus is to save as many as possible.
I just did a calculus project on this very topic. You have 3 loans, Loan A $150,000 @ 6% for 15 years, Loan B $15,000 at 5.3% for 5 years, and Loan C $6000 at 6.5% for 10 years. Your grandmother passes away and leaves you $100 every month for the rest of your life. Which loan should get the $100 first? The Largest Loan, the smallest Loan, or the Highest Interest? After hours of calculating, I found out that the Highest Interest saves the most money. If you place the $100 in additional payments toward the Loans with the Highest interest, then, after paying off that loan, using that loan’s payments (plus the $100) toward the next highest, I was able to save (in this situation) $37,991.37 . In conclusion, I would support the Highest interest loan, being the interest continually is stacking, you must pay it off.
Everyone is different, and I agree that a positive influence will keep a person on track. But I think we all need our own financial plans. There are companies that can help with that and give proper counseling to get rid of debts.