Paying Down Debt – Which Theory Works the Best?

August 20, 2010

In the last few months, I have fielded calls about paying off debts, and which of the many theories about debt pay off works the best.  There are 3 primary theories out there that are being pitched to individuals looking to get out of debt.  I will use the same sample debt with each of these methods, for the sake of comparison.  ($10,000 debt at 24.9%, $8,000 @ 15%, $2,000 @ 5%,  and $50 above minimum payments to add to principal.)

1.  The most common advice I see given in the financial media is to pay off the highest interest debt first.  Why?  Well, if you’re a math geek (I am, but I try not to tell too many people about that) and build spreadsheets to help you make decisions, you will find that paying off the highest interest debt first results in paying the lowest total interest charges over the life of the debt.  I have created countless spreadsheets to try to find a way to pay less in total interest charges, and have been unsuccessful.  If anyone out there can show me a way to do that, I’d love to see it.  The only problem with this method is that momentum and progress are not always readily apparent.   In my example, the 1st debt which happens to have the highest balance AND highest interest rate, is not paid off until the 94th month.  8 years until we see the first debt paid off????  That’s hardly motivating.  But, over the life of these 2 debts, this is the method that produces the lowest interest cost.  There is a total of $18,529 paid in interest.  Math geeks everywhere are clapping!

2.  Pay the lowest balance debt first.  When that is paid off, add what you were paying on that the next lowest debt.  Lather, rinse, repeat.  (OK, it works on shampoo bottles, why not debt reduction strategies?)  Why is this touted as being successful?  Because it is!  People across the country have used this method with success because it creates momentum and is motivating.  Anyone who has watched “The Biggest Loser” has seen a situation that looks impossible become an absolute machine that is unstoppable due primarily to the effects of motivation and new habits.  There is a psychological benefit from making progress.  I’ve seen it myself when I make tweaks to my workout routine or my eating habits.  Progress feels good and builds momentum.  Getting a statement in the mail that shows a $0.00 balance is motivating!  Getting a 2nd statement showing a $0.00 balance makes the progress seem almost habitual.  It feels like success and it is easier to adhere to a program that produces quick results (we ARE Americans who have yet to embrace World Cup soccer with the 1-0 final scores; we want results & we want them now) rather than one with a long and uncertain emotional payoff.   The downside?  A much longer payoff period (128 months vs. 101) and higher interest charges (28.8k vs. 18.5k).  But, and there’s always a but when it comes to personal financial decisions, if someone uses the purely mathematical model and fails to adhere to it, how useful was that effort?

3.  The 3rd method of paying off debt is a hybrid method (designed to make smart people think that they get the best of both worlds above).  This is a completely psychological model, where the debts are ranked in order of “emotional importance” and then paid off in that order.  For instance, an acquaintance of mine got a loan for an engagement ring for his girlfriend.  It was BIG.  And expensive.  And she said no!  This debt is not his biggest, nor is it the highest interest rate debt he has.  But, paying off this debt will alleviate his feelings of rejection and sadness each time he pays that bill.  There are no numbers in this scenario, but as a financial planner who believes in the whole person approach, there is something to like about this method.   It is a quality of life enhancer, by paying off the debt AND by removing a debt with a high emotional importance, you are creating a happier life.  And, the next debt will seem easier to pay off once the highest emotional “bang for the buck” has been achieved.

Which strategy is right for you?   I don’t know, only you do.  The best strategy is any that works!  The merits of each method can be debated, but the progress and life changing impact that can happen when your level of debt goes down speaks loudly.  There are thousands of people who have used each of these methods (as well as many others) with great success.  As long as A STRATEGY is chosen and adhered to!, it will be successful.