Which Debts Should I Pay Off First?

In an ideal world, nobody would carry credit card debt. However, in the real world, debt is very real. Whether debt was caused by reckless spending, an unexpected medical bill or a life event such a job loss or divorce, it is never too late to come out from under the dark cloud of debt.

When struggling with debt, many people become overwhelmed with their bills and do how to start paying them off. One of the first (and most scary steps) is to make a list of all debts, their current balance, interest rate and the minimum monthly payment. No special tools are required for this task: either paper and pencil or an Excel spreadsheet will do the trick, although a spreadsheet makes it easy to update the information in the future. Regardless of your approach, you should create a simple chart like this one:

There are two primary schools of thought on debt payoff and you should pick the one that will help you the most. You should do what works for you personality. With the “debt snowball” approach, you pay off your debts with the smallest balance first. But it is imperative that you’re still making at least the minimum payment on all of your other accounts.  Once you pay off your smallest debt, you can cross that off your list, which visually helps you see the progress you’re making and motivates you to do more. As you move down your list, you add the payment that you would have used with the previous debts to the next one. Hence the name of the “snowball” -- one payment snowballs into another.  

The second approach is to “interest rank” your debts by paying off the debt with the highest interest rate first, since that debt is the one costing you the most money. As before, it is imperative that you’re still making at least the minimum payment on all of your other accounts. Once you satisfied the debt you have chosen to pay off first, you can put that monthly payment towards the next bill to speed up paying off your next one.

The interest ranking approach will save you money in the long run. But it also means that you don’t necessarily get “small wins” along the way by paying off smaller debts (unless they also happen to be those with the highest interest rates). If you are really disciplined and committed to paying off your debts, interest ranking is the best approach. If you need some initial wins, start with the snowball approach and then shift over to interest ranking.

Either way, as you get out of debt, you will improve your credit score and financial standing and working toward your financial independence.

Kent Smetters

Kent Smetters is the Boettner Chair Professor at The Wharton School of the University of Pennsylvania, the Interim Faculty Director of the Penn Wharton Public Policy Initiative, and a Faculty Research Fellow at the NBER. He was the former Deputy Assistant Secretary of the U.S. Department of the Treasury, and he subsequently served as a member of the U.S. Congress’ bipartisan Blue Ribbon Advisory Panel on Dynamic Scoring. Kent holds bachelor degrees in Economics and Computer Science from The Ohio State University as well as an MA and PhD in Economics from Harvard University. He previously cofounded a national registered investment advisory firm that built a new technology platform, grew the firm to over 50 advisors and then sold the firm to a large, publicly-traded company. Growing up in a financially poor family, Kent donates his time to “Your Money” to help families work, save and set goals in order to achieve the most in life. Kent is often cited in major news outlets.