Pay Off Small Balances Before Big Ones

Arithmetically, it makes the most sense to pay down your highest-interest debts first. But psychologically, it helps to feel like you are making progress. I linked to a calculator for using the “snowball” debt reduction method before, but I’ve never really discussed how to use the snowball method. Here’s how it works.

The snowball method

Pay the minimum payment on all your debts except for the smallest. On your smallest debt, pay as much as you can. For example, let’s say you have three debts and you can spend $250 on paying down debts each month:

  1. $10,000 (minimum payment $100)
  2. $5,000 (minimum payment $50)
  3. $1,000 (minimum payment $25)

You would pay $100 towards Debt 1, $50 towards Debt 2, and $100 towards Debt 3. It will take 10 months to pay off Debt 3 this way. In month 11, add that $100 to your payment on Debt 2, which will be at $4,500 at that point (taking your minimum payments into account). Paying $150 per month, it will take 30 months to pay off the debt. Once you have paid off Debt 2, add that $150 to your payment towards Debt 1, which will be $6,000. Paying $250 per month, it take another 24 months, and you will be out of debt! (I know that sounds like a long time; we’re using made-up numbers.)

Why does this work better? Let’s say Debt 1 had the highest interest rate, and you directed your extra income to it, first, it would take 58 months to pay it off. You would have paid off Debt 1 during this time, as well. If Debt 2 was your next debt, it would take another 10 months to eliminate. In total, that would be 68 months, or 4 months longer than using the snowball method.

The numbers won’t always work out that way, but they will usually be fairly close. In other words, while you may succeed a bit faster by starting with the highest interest rate, it’s worth taking psychology into account.

Psychological advantages of the snowball method

The problem with paying your highest-interest rate accounts first is that it often takes a long time to feel like you are making any headway. In my example above, it took nearly the entire length of the payoff schedule to get through just one debt. Starting with the smaller balances, you get more frequent rewards.

According to research by the Kellogg School of Management, it works:

A team of Kellogg School researchers has found that people with large credit-card balances are more likely to pay down their entire debt if they focus first on paying off the cards with the smallest balances — even if that approach doesn’t make the best economic sense.

That has been my experience. When my wife and I were attacking our debt, we put our minimum payments on auto-pilot by creating auto-withdrawals for all our accounts. Then, we directed anything we had left over to our smaller balances until they were paid off. It worked. We paid off our credit card a few years ago, and it has rarely risen since then.

We still have plenty of student loans, but we paid off the small ones with less-favorable interest rates. On the larger, consolidated loans, the interest rates are so low there is little incentive to pay them off early, although we probably will, at some point. First, we have a home equity line of credit to take care of.

[via Lifehacker]