The mathematicians and logical ones among us argue that when you have debt to pay down, the best course of action is to pay down the debt with the highest interest rate no matter the balance. Pay off that debt first, and you’ll pay less in interest overall while becoming debt free.
This sounds like good advice, but I ask you to consider one more thing–cash flow.
The Ying and Yang of Finance
The health of your finances is largely dependent on two things–how much money you make and how much you spend.
Don’t make enough money, and you’ll have trouble paying the bills no matter how frugal you are.
Make a lot of money but spend it all (and then some), and you, too, will have financial problems.
Often, if you’re paying down debt, your budget is TIGHT. Paying $600 or more a month just to service the minimum payments on your debt isn’t that uncommon, especially if you have student loan debt, a car loan, and some credit card bills.
Why Paying Off the Smaller Debts Makes Sense
If you have a small credit card balance, let’s say $2,000, you’re likely paying $80 a month to meet the minimum payment.
Let’s say you have another small student loan debt of $3,000, and you’re paying a fixed payment of $192.
You’re largest balance is $15,000 on a credit card, and that one also has the highest interest rate at 16%. You have a $300 a month minimum payment.
All together, you’re paying $572 each month to make the minimum payments on your debt.
Theoretically, you should pay off that $15,000 credit card first. After all, that makes mathematical sense.
But if you paid off the two smaller debts first, you’ve freed up $272 a month from your budget. You can use that money to snowball onto your large credit card balance, but you don’t HAVE to.
If you suddenly lose your job, it doesn’t matter if you’ve been chipping away at that $15k credit card with the highest interest rate. You still have to find $572 a month to service your debt.
However, if you’ve paid off those two smaller debts, you aren’t obligated to pay that additional $272 because the debt is gone. Now you only need to come up with $300 a month to service the largest credit card debt.
You never know when you’ll be injured and find your salary cut or when you’ll lose your job. For some people in precarious financial positions, it might make more sense to pay off the smallest debt first and improve their cash flow.
Which method of debt repayment do you prefer? Pay off the debt with the highest interest rate or pay off the one that will most improve your cash flow?