The age-old question with many right answers: which debt to pay first?

“Here’s a question for your budgeting conference. I owe on my house, my car, and 2 credit cards. Is it better to pay them off by balance or by interest rate? I’m paying a little bit extra on everything, but feel like I’m getting nowhere. Thoughts or suggestions?”

When she heard I was forming the League of Ordinary Savers discussion group, one of my out-of-town friends gave me the question above to ponder.

It’s been covered by many experts and wondered by anyone who’s ever had lingering debt hanging over their heads. So I’m not sure if my opinion sheds any new light, but since she asked, here goes.

She encapsulated the two main schools of thought in her question.

One: Tackle your debts in order of smallest to largest balance. Pay the minimums on all your debts but throw everything extra at the smallest debt. When it’s gone, roll what you were paying toward the next-smallest debt, and when that’s paid off, put all the money that was going toward those two into paying off the next-smallest. Some call this a “debt snowball”; you can imagine the ball of money getting larger and larger as it absorbs smaller debt payments. When you get to your largest balance, you can pay as much as you were for all the smaller debts, so it goes away relatively fast. Seeing debts get eliminated quickly earlier in the process gives an emotional satisfaction that keeps you motivated to continue paying off debt at an accelerated pace.

Two: Aim for your highest-interest debt first, and go from there. That way, you’re eliminating the debt that’s costing you the most cents on the dollar, and by the time you get to the end of your debt journey, your last one will be lowest-interest and so most of the money you put toward it will go to principal rather than interest.

With either method, most people agree you should pay off everything else before you start paying your mortgage. For the small-balance-first camp, this makes sense because your mortgage is probably your highest balance. For the lower-interest camp, even if your mortgage isn’t your absolute lowest-interest debt, the tax break you get for itemizing interest typically offsets that and makes it your least onerous debt.

Me, if I have a school of thought, it’s that there are good debts and bad debts. Or at least, debts that can bother a person more than others.

Confession time: When my family started our journey out of debt, we had 5 credit card balances, 2 overdraft balances on checking accounts, 1 unsecured loan of consolidated credit card debt, 3 student loans (with another college education spelling even more loans), 2 mortgages, 2 home-equity loans, and 1 interest-free loan from a parent. Whew!

My “method” has been a combination of tactics. I first focused on the overdraft balances. They were some of the higher-interest debts, and they were easy to pay (we just had to transfer any leftover money into the overdraft account). But more important, they were the most demoralizing debts. Seeing our checking accounts in the red signaled to me that we were not successfully living within our means, that we weren’t even holding steady, let alone getting ahead.

Once the overdrafts were gone, I focused on the credit cards and the unsecured loan. I went by interest rate and paid off the higher-interest ones first, regardless of balance. Pretty practical, although the last credit card we paid off had a lower interest rate than one of our mortgages and a couple of our student loans! But I just really wanted to say I was credit-card-debt-free. It was a huge motivation for me.

But once we were free of that consumer debt, I went for the least-expensive loan: the one to my dad. There were no minimum payments and no interest. He’d told me to take my time and pay him whenever, and he never complained, even when I went more than a year between payments. But the debt felt personal. There was a face on the other side, a beloved one, not just a giant corporation making money off my financial instability. I just couldn’t think of anything else; I threw myself into paying my dad back.

That felt pretty good; we had no credit card debt and didn’t owe any family members! So we slacked off a bit while we focused on other goals: building an emergency fund and financing an elaborate estate-planning and adoption process. We even started spending more on our “wants,” such as travel.

Student loan debt didn’t make me feel quite as ashamed as consumer debt or family debt; I felt there was something valuable to show for it, however intangible. But recently I’ve felt we needed to eliminate them so we could focus on moving and purchasing a bigger home for our growing family. So we’ve been hitting those loans hard, and we’ll be free of them in less than three years (maybe closer to two!).

The mortgages will still be there, and I’m not sure if I’ll put more money into them or just keep paying the minimum until we sell the homes. With more money in the bank vs. equity in the homes, we’ll have more flexibility with how we can use the money when it’s time to move.

When we’ve resettled, I imagine I’ll put a bit extra toward the new mortgage each month; after all, the debt-repayment habit is a hard one to break once it’s there! And I do want to be mortgage-free before we retire, which may be sooner than 30 years once we take out our new mortgage. But like many people, I don’t see a mortgage as a terrible debt. As long as it’s not causing other budget problems, I don’t view it as a failure or a flaw.

So, to sum up, what debt do I think you should pay first? Well, I do think you should focus on one debt at a time, so they don’t get ignored and so you see real progress to keep you motivated. But in the end, I don’t think it matters whether you conquer your debts in order of interest rate, balance, or whether they’re “good” or “bad.”

What matters is that you conquer them in the order that keeps you fired up. The order that makes debt payoff a triumphant game rather than just a grim death-march. Go after the ones you just feel  are worse, whether you view higher interest as the worst villain, or nagging little small-balance debts, or debts that represent a past mistake or a family obligation unfulfilled.

Focus on the debts in the order of how much they bother you. That’s what matters to you, so that’s what will work best for you.

The many-headed debt monster! Photo by Wolfgang Sauber.

The many-headed debt monster! Photo by Wolfgang Sauber.

2 thoughts on “The age-old question with many right answers: which debt to pay first?

  1. bluesfemme

    I agree. Logically you should work out which method costs you the least over time – but we’re not logical creatures (or we wouldn;t get into these scrapes!) so i think as long as you are addressing debt you should go after what is achievable in the relatively short term (sub-12 months) and bugging you the most, first.

    At the moment, somehow I can’t force myself to hand over the money i’ve saved for a debt. It’s a ‘bad’ loan – $3000 for sofas, but on a 0 rate til October, with $4.95 account fees each month. I’ve now saved up the money, but don’t want to hand it over, as my interest received, after tax, is $8/month. I feel like the extra $3/month will start wiping out the past account fees, but hubby just wants the debt done and dusted! I guess i got the sense of achievement when i saved up the money, but he hasn’t yet.

    PS: Thanks – i followed you over from SA. From J Money i got doing a monthly net update; from you, I got setting out my financial goals at the start of each month. I won’t ever do a budget – it feels like someone telling me what to do which i will always rebel against – but between you guys and the whole SA community I’m so much more mindful of my money!

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  2. Rosie the Budgeter Post author

    Hey, if you’re coming out ahead, I don’t see anything wrong with holding the money for a while! As long as you pay it before interest comes due. 🙂 Thanks so much for following my blog; glad I could help! Budgets are definitely not for everyone, nor are they necessary for everyone, but I’m a natural spender and so is everyone in my family, so I well know where we’d go if I let go of the budget. Back where we came from! 🙂

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