There are generally two schools of thought when it comes to paying down debt:
But neither of these methods addresses the true issue on their own, which is minimizing interest payments in order to pay down the principal balances more quickly, paying it off in a shorter period.
That’s why I prefer to combine the two theories into one comprehensive method that reduces the debt while also minimizing the amount of interest that will be added along the way.
Looking at the situation strictly from a balance standpoint or an interest rate standpoint does not tell the whole story. If you have several debt obligations, you will be better served to look at the interest being charged on your statement for a more accurate view of your situation. The interest you pay should be the determining factor in which obligations get paid first. Take the following rough examples of debt obligations:
- Principal balance of $10,000; interest rate of 1%
- Principal balance of $6,000; interest rate of 10%
- Principal balance of $2,000; interest rate of 16%
Assuming either of the more common debt-reduction methods were used, some people would pay the highest balance or the highest interest rate first. However, while those methods would work toward paying down some of the debt, the second obligation, although significantly lower in dollar value than the highest obligation and lower in interest rate than the highest value would end up costing the most in interest during that time. That is why you need to take a different approach and analyze each of your debt obligations to see which is costing you the most in interest, which in turn will lead to a longer amount of time and resources to eliminate, especially if you are only paying the minimum required payment.
The issue gets even more complicated if you are looking at interest rates alone, specifically on credit cards, because many times there are purchases with different interest rates attached on the same card. In addition, as time goes on the rate on a particular card can fluctuate so as to increase or even decrease after your debt-reduction plan has begun. That makes the strategy of looking at interest summary even more important. It looks at the bottom line figure of how much interest you are paying on each obligation as a whole. This way, you are seeing the total impact of the outstanding debt plus the applicable interest rate being charged on those outstanding balances, not just the balance or rate on their own.
It may involve a bit more work than simply saying “I will pay off the highest balances first” or “I will pay the balances with the highest interest rates first”, but in the end you will save quite a bit of money in interest charges, and even more time since the interest will not compound and continually increase the balances owed as quickly. You may need to re-evaluate your strategy every few months or so just to make sure that your payments are having the most positive impact on your debt situation, but it will certainly be worth it once you start to see a noticeable change in your situation.
What do you think would work best for your situation: knowing that a debt is completely eliminated first or knowing that you are paying down your debt while ensuring that a minimal amount of interest is being added on top of it? Or, do you have a totally different approach to tackling debt?