Making Sense of the Various Debt Payment Strategies


Personal finance is much more about the “personal” than the “finance,” as many (myself included) have often noted. Said a different way: understanding how we think, what our goals and objectives are, what we fear, and what motivates us is vital to our financial success. This is true not because it’s always mathematically the absolute right solution – but because it recognizes who we are and how we think.

Such is the case with paying off your consumer debt. Different theories are easy to find, but which one will really help you most effectively pay off your debts? Which will help you stay motivated to complete a process that may take years depending on your income, expenses and debt load?

Regardless of which debt payment strategy you use, let’s set some guidelines:

• First, you should be operating your finances with a monthly spending plan (for tips, see here). This will maximize the efficiency of each dollar of income you have available. No dollar is wasted, or lost to frivolous spending.

• Second, make a complete list of your non-mortgage debts. List every credit card, car loan, personal loan, payday loan and student loan you have.  It may be painful to see, but ignoring it won’t make it go away and doing so will make it much more painful in the long-run.

• Third, make sure you’re making the minimum payment on each debt and that they are included on your spending plan mentioned above. Falling behind on one loan to get ahead on another doesn’t make sense.

• Next, do you have additional money available each month (above the minimum payments) to go towards paying off debt? If you don’t, it doesn’t matter which order you’re paying the debts as you’re only making the minimum payments. You will need to either increase your income or decrease your expenses.  Even better, do both!

So let’s assume you’ve listed your debts and have some available cash flow each month to put toward paying them off faster than scheduled. Here is where the differing opinions arise. When it comes to debt elimination strategies, a quick search on the Internet will provide many opinions about how to do it most effectively.

Advisers will advocate:

• Paying the highest interest rate balances first
• Paying the smallest balances first
• Paying the most “painful” ones first (for example, owing the IRS, or a family member you have to see at Thanksgiving!)
• Paying “secured” debt first (since a failure to repay them could cause you to lose your car, for example), then payoff the unsecured debtors
• Combinations of these strategies, creating an even more complicated repayment strategy.

They’ll be given fancy names like the “debt snowball”, the “debt avalanche” and the “debt tsunami” (these are all actual names of payment strategies!). Each one seems to be trying to out do the previous.  What’s next, the “debt zombie apocalypse”?!

It’s certainly true that arguments can be made for any of these (and the many other) strategies out there, but which is best? Can we keep this simple – and effective – or do we need to out think ourselves? And where do non-monetary issues, like motivation, come in?

Usually (**see my note below) my recommendation is to list the debts smallest to largest and pay them off in that order. When the smallest debt is paid completely, take the full amount you were paying on that debt and apply it to the next debt on the list. This is in addition to the minimum payment you’re making on that next debt.

Yes, this does mean to ignore the interest rates being charged.  However, in many cases the interest rate difference is not significant enough to ignore what works better in the real world – when emotions and motivations are taken into account.

Let’s look at an example to see my point:

In our hypothetical example, imagine having the following debts:

debts list
Maybe they’re student loans, car loans, or credit cards. The source doesn’t matter. The minimum payments total $1,000, and assume further that through the use of a great spending plan we have an extra $500 per month to put towards paying them off early.

If you pay them using “smallest to largest balance”, here is the result:

smallest balanceIf you pay them using “highest to lowest interest rate”, here is the result:

highest interestIn both cases, it took 19 months to pay off all of the balances. The interest savings you would realize if you paid the highest rate first would be only $113.28! This works out to less than $6 for each of the 19 months.

Here is the key for me: Using the smallest balance first method, the first victory (i.e., paying off the first item) occurred in only 5 months. Think how great it would feel to get that first one out of your life! Then the second is paid off in only 7 more months and the third is gone only 2 months after that! I see those victories as being huge in maintaining your motivation to keep going.

It would take 14 months to pay off the first debt using the highest interest rate first method.  If you can stay motivated that long without paying one off, feel free to do so and save the $6 per month. But I’ve found that most people need the quick victories to keep going (remember, it’s more “personal” than “finance”!).

More research is coming out to back up this theory. In August 2015, a new study published in the Journal of Marketing Research found that paying off the smallest balance first led to more debt being paid off overall.

“Winning what are known as ‘small victories’ by paying off small debts first can give consumers a real boost in eventually paying off all their debts,” write the authors of the study, Alexander L. Brown (Texas A&M University) and Joanna N. Lahey (Texas A&M University). “The reason is that meeting a small goal provides the motivation to then meet a larger goal.”

Obviously, the most important factor in paying off your debts is to pay as much as possible towards them, regardless of the order you pay them off. But if you have funds available to make extra payments, use them in a way to keep you motivated to finish the task. For most of us, it will be paying the smallest balance first.


** Note: Generally this will be my advice to coaching clients, however there are always exceptions! For example, if a client had a $10,000 / 0% auto loan and an $11,000 / 21% credit card, clearly the credit card should be paid first, even though its balance is slightly larger. Common sense should always be used when determining how to proceed! A case like this is exceptionally rare, though.

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