There are many ways to pay down debt. Some theories from well known individuals have provided people with an inefficient way to pay off debt. The most efficient way to pay down debt isn't even the most popular method! My goal is to provide you with the truth and information you need to be successful.
There are two main ways to pay down debt. One of the most common theories are to pay off the smallest loan amount/balance first. The famous financial guru Dave Ramsey leads one of the most popular financial programs and uses this inefficient debt payoff method. Most people don't realize it's inefficient because he doesn't tell anyone. Ramsey isn't doing it with evil intent (which I will explain) but he should be providing a disclaimer stating that he isn't providing the most efficient method. The second main way to pay down debt, is paying off the highest interest rate loan first.
An example will help you understand the differences. We have three loans with the following balances and interest rates: $10,000 at 4%, $6,000 at 5%, and $3,000 at 3%. Paying off the smallest loan first would be paying the $3,000 loan first, the $6,000 loan second, and the $10,000 loan last. Paying the highest interest rate loan first would be starting with the $6,000 loan, the $10,000 loan second, and the $3,000 loan last. Each option will require you to pay the minimum payments on all loans at a minimum, but any extra money you can put towards the loans go toward the respective loan listed in the strategy.
Each situation involves snowballing. Snowballing is an extremely effective tool because each time a loan is paid off, it frees up that money to pay off another loan at a faster rate. That happens over-and-over again until each loan is paid off. In both scenarios you have to pay at least minimum payments on every loan to avoid defaulting. In our examples we will assume we go out one less time per month and save $20 to add above minimum payments.
Using the snowballing method with the highest interest rate loan is the most effective and efficient way to pay off debt. In this method you continue to pay minimum payments on your loans, but this time you focus on adding your extra $20 to the loan with the highest interest rate and continue to snowball into the highest interest rate loan.
When you focus on snowballing the loan with the smallest amount/balance and adding $20 to that loan, the result is faster snowballing initially. This is the very popular method for paying off debt that is pushed by Dave Ramsey, but unfortunately this isn’t the most effective or efficient way as mentioned before. It likely became a popular method due to the initial mental “victories” you get from paying off loans quickly initially. That's why Ramsey isn't teaching this with bad intentions, because it does work and provides mental victories. He should be telling people that there is a more efficient way but it's tougher to do mentally.
The eBook on our free membership page provides a resource to calculate debt. You can change the debt payoff method to see the differences. You will notice that the total interest paid and the length of time you are paying off the loans is lower using the highest interest rate method. This calculator is an excellent tool for your loans and determining which loan should be paid first and how to snowball that into the next loan. Start being as efficient as possible today by paying the highest interest loan first and start saving yourself money!
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