You have multiple debts: a credit card or two, some student loans, an automobile loan, a mortgage. How can you decide which to pay off first?
First and foremost, you should save a small emergency fund (or cash cushion), and make all the minimum payments on every loan. Don’t miss any payments, if possible. Then, with remaining money that you have leftover, you’ll need to decide which debt to aggressively tackle first.
Here are three strategies that help you repay debt.
#1: Smallest Balance
One popular strategy is to pay down debts based on the total balance size, from smallest to largest. This has two benefits.
First, you increase your cash flow each time you get rid of a debt, freeing up that money to be applied towards other loans. Second, you enjoy the mental and psychological victory that comes from crossing a debt off your list, and this sense of accomplishment keeps you motivated.
#2: Highest Interest
The competing popular strategy is to repay debt based on interest rate, from largest to smallest. This is the classic debt-payoff strategy and tends to be the one that’s most recommended by financial professionals. However, that doesn’t necessarily mean that it’s the best; it’s simply the most traditional way to think about debt paydown.
This strategy might mathematically make the most sense, since you’d pay the least interest overall. However, it might not produce the same satisfaction of crossing something from your list as the strategy listed above.
Ideally, your high interest rate loans will also have small balances, which hopefully means you can achieve both strategies (smallest balance and highest rate) while tackling the same debt.
#3: Most Annoying
Yet another strategy says you should first repay whatever debt bothers you the most — regardless of balance AND interest rate. For example, if you’re bothered by a small zero-percent interest personal loan that a friend gave you, repay that friend first, even though the balance is tiny and the interest rate is zero, because it’ll help put your mind at ease and allow you to sleep easier at night.
If you’re more bothered about your mortgage (because you like the idea of owning your home) than your student loan, you might want to pay the house off first, according to this theory. If you’re bothered by a credit card debt because of the high interest rate, pay that loan off first. Just pay off whatever helps you sleep at night.
Which strategy should you choose? Whatever works for you. As long as you’re paying off your debt (as aggressively as possible), you’re on the right track. Focus on getting rid of your loans, regardless of whether or not your friends think you’re picking some “optimal” plan. Remember — the best plan is the one you’ll actually stick to.
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