Two Approaches to Debt Elimination
Wednesday, 26th April 2006 (by J.D.)This article is about Choices, Debt
Nearly every financial adviser — from accountants to brokers to books — advises that debts should be paid off in a particular order: from highest interest rate to lowest interest rate. While this method makes sense from a mathematical point of view, it makes less sense from a psychological point of view.
Assume a typical young woman in her mid-twenties who awakes one morning to realize that she’s in debt and who decides to do something about it. She might be burdened with the following hypothetical liabilities:
- $20,000 college loan at 5%
- $8,000 credit card balance at 12%
- $2,000 computer loan at 10%
- $3,000 car loan at 4%
Most financial gurus would advise that the debts be paid off in the following order:
- $8,000 credit card balance at 12%
- $2,000 computer loan at 10%
- $20,000 college loan at 5%
- $3,000 car loan at 4%
This payoff plan does, indeed, make the most financial sense if you have the discipline to adhere to it. By paying off the high interest rate debt first, you’re minimizing the total you will eventually pay in interest. But this method does not work for everyone.
I struggled with debt for a decade. I made several abortive attempts to eliminate my debt using the highest-to-lowest method, and each time I failed. Why? Because my highest interest rate debt was also my debt with the highest balance. Psychologically, I felt defeated; I could pay on this debt for months at a time and never seem like I was making progress.
I found a better way.
In his book The Total Money Makeover, Dave Ramsey advocates the Debt Snowball approach to debt elimination. Using the Debt Snowball method, you ignore interest rates when determining the order in which you’ll pay off your debts. Instead, you organize them from smallest balance to largest balance:
- $2,000 computer loan at 10%
- $3,000 car loan at 4%
- $8,000 credit card balance at 12%
- $20,000 college loan at 5%
After you’ve listed your debts from smallest to largest, pay the minimum amount on all of them except the smallest. Throw every dollar you can scrimp and save against your smallest debt until it has been eliminated, then move on to the next-smallest debt.
Ramsey advocates this method because of the subtle psychological reenforcement it provides. It’s “behavior modification over math”, he claims. And he’s right. The most important thing in paying off your debts is to pay off your debts; the order in which you do so is ultimately irrelevant.
The Debt Snowball method has vocal detractors who complain that the math doesn’t make sense. And it’s true that if you use this method, you will pay more in the long-run than if you had the discipline to pay off your debts from highest interest rate to lowest interest rate. But, again, what’s important is to just get the debts paid off. Know yourself. Choose the method that makes the most sense for you and for your situation.


[...] This dichotomy — Best Decisions versus Financially Smart Decisions — reminds me of the Debt Snowball method of debt reduction I described last week in Two Approaches to Debt Elimination. Paying off your debts from smallest-balance to highest-balance doesn’t make the most sense mathematically, but for many people it is the Best Decision because psychologically it provides short term financial victories that lead to long-term financial independence. [...]
[...] If, like me, you’re following the debt snowball method of debt reduction, check out Mr. Peanut’s Debt Snowball Calculator. [...]
[...] For years, as I struggled with debt and reckless spending, the only personal finance books that appealed to me were those promising quick riches. A few Christmases ago, after listening to my financial woes, a friend mailed me a copy of Your Money or Your Life. I flipped through it half-heartedly, and then put it on the shelf. It sat there for two years before my debt burden became so overwhelming that I pulled it down and read it. I was impressed. Another friend then recommended Dave Ramsey’s The Total Money Makeover. I put Ramsey’s “debt snowball” method to work, and suddenly saw progress in debt elimination where I’d never been able to succeed before. [...]
[...] You hear me say this often: Do what works for you. There are many personal finance books, and a lot of theories. Some have survived the test of time, but not all of them work for every person. Try what the experts recommend, but if the advice doesn’t help you reach your goals, look for a variation. (For example, I had trouble paying down my debts until I followed Dave Ramsey’s advice to use a Debt Snowball, paying off my smallest debts first instead of those sporting the largest interest rates.) [...]
[...] You might notice that there’s some conflicting advice in this thread. “Pay off your highest interest rate debts first.” “No! Pay off your lowest balance debts first.” Etc. Different methods work for different people. Yes, there are theoretical “best methods”, but so what? [...]
[...] Find a system that works for you and focus on it intently. There are many approaches to debt reduction. Do what works for you. If you need a credit counselor to help guide you, find one. If you have the time and ability to work extra jobs, do it. [...]
[...] I have a lot of credit card debt — how do I pay it off? Don’t listen to anyone who tells you there’s only one way. There are a number of approaches, and the important thing is to pick the one that works for you. I’ve written about two popular approaches to debt elimination. Pick the one that works best for your personal psychology. [...]
[...] (For more on this, including some actual figures, see my entry on two approaches to debt elimination.) [...]
[...] There are also differing opinions on how to best pay off existing debts. The mathematical winner is to pay off the debts with the highest interest rates first. However, despite what my high school math teacher led me to believe, mathematics isn’t everything. Many times, however, the loans with the highest interest rates are also the largest. Paying these off first can be discouraging since progress is slow. Another method that combats this is called the Debt Snowball. More can be read about it here, but the premise is to payoff the smallest debts first regardless of interest rate. Then when that debt is paid off, move to the second smallest but use the additional money from the missing debt payment. By the time the largest debt is being paid off, the extra payments will have ’snowballed’ causing it to be paid off quickly. [...]
I’m 57, unemployed, looking for work. I owe $26,000.00 in two credit cards a small loan, and my car loan. I just cut up my VISA, and my Pepboys cards. I feel better already.
I’m trying to get out of debt and started to track my expenses a lot closer. I tried MS Money to do this and also found this handy web site; http://www.expenseview.com. I liked the site because it was free and it really broke down where I was spending my money.
If you are trying to reduce your debts, you need to avoid the Top 10 Debt Reduction mistakes at all costs: http://www.3debtconsolidation.com/debt-reduction-mistakes.html
The first rule is to spend much lesser than you earn, so that you have lots of disposable income left over to pay off any outstanding debts…
No Financial advisor would ever recommend paying off in this order: (and if they did, ignore them)
# 2,000 computer loan at 10%
# $3,000 car loan at 4%
# $8,000 credit card balance at 12%
# $20,000 college loan at 5%
5%apr of 20,000 is more than 12%apr of 8,000.
You shouldn’t look at the interest, look at the total cost.
[...] Frugal for Life hosted Carnival of Debt Reduction #34, and this week’s Flashback comes from Get Rich Slowly: Two Approaches to Debt Elimination. [...]
The financial cost (Snowball vs Rational) probably isn’t really as much as you might imagine in many cases. For one thing, large percentage loans are probably often the smaller ones anyway, so the two methods will align to some degree. But for amusement sake, I did a rough run of the numbers, assuming the minimum payment was simply the interest (which makes for a minimum payment per month of around $190) and assuming $500/month paid in to debt.
The results with Snowball is your first loan paid back after 7 months, as opposed to 24 months for Rational.
After 37 months, you have paid all except the college loan on Snowball, whereas Rational would still have two loans (Car & College), but the interesting thing is that you’re only about $600 worse off (ie, screwing up for just 1 month would make you about even). So any emotional benefit from Snowball is almost certainly enough to make it the better “rational” choice.