Conventional wisdom says that when paying off debt, you should pay off the account with the highest interest rate first, then the second highest rate, and so on. The reasoning behind this method is that you pay less interest, and therefore it costs you less money if you pay off the highest interest accounts first. That is a valid point if you have an account with an incredibly high interest rate or a very long term, high interest loan such as a mortgage. But if you have a lot of credit card debt with similar interest rates, or student loans that don’t vary much with their rates, it may be more effective to attack the account with the lowest balance first.
There are three specific advantages to attacking the lowest balance first:
First, by paying off the account with the smallest balance, you will achieve your first milestone sooner than if you attacked the account with the highest interest rate if it has a much larger balance. This will provide you with a more immediate sense of accomplishment and reinforce your goal of being debt-free.
Second, having paid off one account sooner will simplify your finances by having one less bill to pay each month. One of the obstacles that people have to overcome is the complexity of managing their finances. Most people have on average anywhere from ten to twenty bills to pay each month from their mortgage, utility bills, credit cards, etc. By paying off one credit card sooner, that’s one less bill to worry about.
Third, paying off an account frees up money each month. You would then apply that freed up amount to the next lowest balance account and so on. The advantage of being in this position sooner, rather than later is that you can capture that freed up amount. In the event of a financial setback, such as a job layoff, you have decreased the amount of money you have to pay towards your debt. That money could temporarily be used in an emergency situation.
These advantages become even more important if you consider similar time factors. If you were to run an amortization schedule on both payoff scenarios (highest rate vs. lowest balance), you will find that there is not a significant difference in the number of months it takes to pay off your accounts. Meaning to say, it will take the same amount of time to pay off your debts whether you start with the highest interest rate or the lowest balance. The difference in interest payments becomes much less significant.
In addition, if you use the snowball effect (wrapping freed up money into paying the next debt and so on), then you would accelerate your debt payment in about the same amount of time. Especially when aiming to have all your debt paid off within a five year time frame (a good financial planning principal).
So what does it matter as to which method to use? Take a closer look at the debt you are trying to pay off and consider the factors mentioned – differences in interest rate and timeframes. Achieving a quick win, eliminating a monthly bill, and having cash on hand for an emergency are all good reasons to take advantage of paying off the smallest balances first.