When it comes to debt payment, you have probably heard the advice to pay your highest interest rate debt first. But is this the most effective debt-reduction strategy?
Yes and no.
It always depends on your goals and on how good you are at sticking to your plans and staying motivated.
The strategy of paying your highest interest rate debt first is also known as the debt avalanche method. This is one of the most popular strategies used for paying off debt, together with the debt snowball method.
Both strategies are based on the idea that you choose one debt on which you will make higher monthly payments while keeping the rest at a minimum. But while the snowball method focuses on paying off the smallest debt first, with the debt avalanche you tackle the highest interest rate debt first. This will allow you to save money from that interest rate by paying it off faster.
The common factor is that once you extinguish the first debt, you will use that amount towards the next debt you decide to pay off. While it will likely take the same amount of time to pay off all your debts, with the avalanche method you end up saving some extra money from interests.
So it seems quite reasonable to start paying off your higher interest rate debt first, right? Well, not necessarily.
While you do end up saving a few hundred dollars, many social science studies show how this may not be the best choice. In fact, several pieces of research like the one conducted at Boston School of Business, show how concentrated repayment strategies tend to work better in that they “boost consumers’ motivation to become debt-free”.
This means that people find it easier to stay motivated and stick to their debt payment plan when they see actual progress. And while both strategies allow you to make progress, completely paying off debt, no matter how small, has a more motivating effect.
The bottom line is if you find it hard to stay motivated and on track and you need clear signs of progress, maybe you should start by paying off the smallest debt. If, on the other hand, you’re looking to save some money, choose the debt avalanche method.
As with everything related to personal finance, debt payment strategies are, well, personal. Choose the one that suits you best and that will keep you more motivated to stick to it.