Two approaches to debt elimination

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.

The Traditional Approach

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.

The Debt Snowball

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 reinforcement 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.

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There are 7 comments to "Two approaches to debt elimination".

  1. Robert k. Tompsett says 07 April 2007 at 16:56

    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.

  2. Ron Davis says 12 April 2007 at 21:18

    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; I liked the site because it was free and it really broke down where I was spending my money.

  3. Omniboy says 06 March 2008 at 00:00

    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.

  4. Peter N Lewis says 24 June 2008 at 07:00

    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.

  5. Theresa says 12 December 2009 at 20:14

    Maybe someone can answer this for me. I just bought “The Total Money Makeover” yesterday and am almost done reading it and really love the way the steps are laid out. The thing I can’t seem to find an answer on is do I include charge-offs in my debt snowball? At some point they will need to be paid off but since I am no longer accruing interest on them and I don’t make monthly payments on them, while they are personal debt that needs to be paid off, do they need to be included in step two or should I wait and tackle them later?

  6. Holden says 20 January 2010 at 11:54

    I just started Ramsey’s Baby Step #2 and really wondered about his Snowball Method and recommendation to pay off smallest to largest debts (regardless of interest rate). His method seemed to fly in the face of some of his general attitude towards debt (particularly with regards to credit cards and interest rates). But I really think there is a HUGE advantage to the pyschology of having some quick “wins”. I know that it’s a motivating factor to me to cross things off my debt list. I’m actually keeping track of my progress at – – it’s a great way to hold myself accountable. And while I may have the discipline to pay off my debt with the other method you outline (the one traditionally advocated by financial advisors), I have to be honest with myself that it’s a lack of financial discipline that got me in the mess I’m in. Anyways, enjoyed the article and I for one think Ramsey’s Snowball Debt approach – especially the pyschology behind – makes the most sense.

  7. Debt F. Destiny says 01 June 2010 at 09:03

    Credit counseling is for consumers that have a relatively low amount of debt and can keep current with payments. Debt settlement is for high balances and past due accounts.

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