Getting out of debt is one of the most liberating feelings you can experience. The question of which loan to payoff first is one that comes up often - and it's worth looking at different strategies to do so.
Today I want to contrast two different debt-payoff strategies we've written about in the past. Both of them are used in a "debt snowball" plan, where you make extra principal payments toward paying off a loan early. In my previous blog I showed the total interest paid using different payoff strategies. Looking at loans of different maturities, interest rates and balances I calculated the total interest paid under each scenario. My analysis showed that you're better off paying down the loan with the highest interest rate first, then paying off the loan with the next highest interest rate second, and so on until all loans have been paid off - including your home. The obvious benefit of this strategy is that it costs you the least amount of money. The downside is that the highest interest rate loan may not be the smallest loan, so it will take you longer to payoff the first one.
In our Dave Ramsey book review Steve points out that Dave's strategy is to list all of your consumer debt in order from the smallest balance to the largest balance. Dave ignores the interest rate on the loans and instead focuses on paying off the loan with the smallest balance first. Why does he do this? Dave's goal is behavior modification - getting you to build new habits - and we know from Psychology 101 that positive reinforcement is the most effective way to change behavior patterns. He wants you to experience how awesome it feels to get a loan paid off as quickly as possible. The feeling of success, the rush of endorphins, the pat on the back, the sense of relief - they all accomplish one thing - they reinforce good behavior. He reckons that once you know how good it feels to get out from under the burden of a loan for the first time, you'll want to continue the process with the next loan. The benefit of this strategy is that you get a "quick win" and that notch in your belt will spur you on to payoff the next smallest loan, and so on until you're debt-free.
So which of these strategies should you use? Both of these strategies work, but either one may be more effective for you depending on your personality and discipline.
If you are very disciplined and care most about minimizing total amount of interest you pay, payoff the high interest rate loan first. One way to be disciplined, even if you don't consider yourself to be so, is to have the loan payment paid electronically from your checking account each month, so you don't have to make a conscious decision about it - it's on autopilot. It takes more energy to stop or change the payment than it takes to do nothing at all, once the automatic payment is setup. This is my preferred method. All of the emotion of paying is gone, except for how I feel when I see a loan balance dropping quickly. All of the work is gone - the bills get paid in my sleep for all I know.
If you're prone to taking weekend trips on a whim, or buying something you just "gotta have" you might be better off going for the quick win by paying off the loan with the smallest balance. After you payoff your first loan, reward yourself with a pat on the back and savor the moment. Hopefully you'll retain that feeling of success the next time you walk past the shoe department at Nordstrom and you'll resist an impulse buy in your quest to become debt-free. Of course, you can still have these loans on auto-pay from your checking account, and you probably should.
Either one of these strategies will put you on a better financial foundation. The key is to use one of them starting today. You'll be amazed at how good it feels.