The Right Order to Pay Off Your Debts
So, let’s assume that you’ve decided to start paying off debt, but you have multiple debts and aren’t sure which one you should pay off first.
How should you go about making that decision?
We’ll answer that question in this post.
Momentum or Math?
To begin, let’s talk about two of the primary strategies people use to pay of debt.
The first method we’ll discuss is effective for people who get a strong sense of satisfaction from an early victory as they set out to accomplish a goal like paying off debt.
This method is called the Debt Snowball and using this approach you’ll start by paying off your smallest debt first, then the next smallest, and so on until you’ve paid off all of your debts.
Using the Debt Snowball allows you to score a quick victory which may serve as a helpful emotional boost to propel forward toward paying off all your debts.
The other method is called the Debt Avalanche and it prioritizes monetary or financial efficiency over the psychological boost you might get from the debt snowball.
In the debt avalanche, you’ll start by paying off your debt with the highest interest rate first, then pay off the debt with the next highest rate and so on until you’re debt free.
If you prefer to prioritize the path that saves you the most money, the Debt Avalanche is for you.
Let’s compare these two methods so you can more easily see the differences.
The Snowball vs The Avalanche
Suppose you have the following debts and $1,000 each month that you want to direct toward paying these debts off.
The table below contains a summary of the amount of interest you’ll pay and how long it will take you to pay off the debts:
So, in this scenario, you’d get your first debt paid off six months faster using the Debt Snowball method, but you’d save $1,386.28 in interest by using the Debt Avalanche and focusing on your highest interest rates first.
Also, in this case, you would have all of your debts paid off first using the debt avalanche, but the total amount of time it takes to pay off your debts could vary between the avalanche and snowball based on the actual interest rate, size of the debts, and how much cash you can direct toward your debts each month.
One is not necessarily faster than the other.
Personally, I’m a fan of whatever method is more likely to encourage you to pay off debt. The Debt Avalanche is only more beneficial if you keep paying off your debts, so if you think you’re more likely to stay on track using the Debt Snowball then that’s the route you should take.
Shoulda, Coulda, Woulda (The debt quadrants)
I hope the math we just walked through helps you understand your debt situation better, but debt retirement is not always as simple as just lining up your debts in a certain order and picking them off one at a time.
If you ignore the other facets of your financial life, you could liberate yourself from debt only to experience regret that you weren’t setting aside some of your money for saving and investing.
Your financial plans should be made with your total financial picture in mind. Debt is just one part of that.
For example, what if you spent years paying off a mortgage and missed out on thousands of dollars in compounding interest that you’ll never get back.
That could be very disappointing, especially if your mortgage interest rate is considerably lower than the returns you could have been harvesting by investing instead.
Don’t get me wrong. I love the idea of being debt free, but it shouldn’t come at the expense of your overall financial well-being.
There’s more to consider.
And to help with that, I like to categorize debts a couple of different ways:
Secured vs. Unsecured Debts
Many debts are issued against collateral like a home, car, or boat that provides a safety net for the lender in case a borrower defaults on a loan.
This is known as secured debt.
If the borrower fails to keep their end of the bargain, the lender can repossess the collateral and sell it to recoup the money they provided for the loan.
Naturally, the opposite of this is unsecured debt.
Unsecured debts don’t have collateral. Credit cards, consumer loans, and student loans are examples of unsecured debts.
The reason this distinction is important to understand is because unsecured debts will have higher interest rates than secured debts because unsecured debts place higher risk on the lender.
Appreciating vs. Depreciating Assets
Another debt differentiator is whether or not the loan is on a depreciating or appreciating asset.
A house is an example of an appreciating asset while cars are a common depreciating asset.
Appreciating assets are typically safer for both the borrower and the lender because a) they’re collateralized, and b) the collateral is unlikely to be less valuable than it was when the loan was originated.
Depreciating assets are riskier to borrow against because they lose value over time.
For example, cars depreciate so rapidly that it’s not unusual for the value of a car to fall below the amount of principal remaining on a car note.
So, if you borrow a bunch of money to buy a car and decide to sell it later, you may have a difficult time recouping the money you owe on the car loan.
The Debt Quadrants
Now, if you take these concepts, secured vs. unsecured, and appreciating vs. depreciating, and put them into a visual cross-section you can quickly see where the safer and more dangerous debts reside.
I call this the four debt quadrants and here’s an example of what I’m talking about:
The cooler zones in the graph indicate places of relative safety while the hotter zones represent risker areas for debt that should be avoided.
So, if you have a debt in the secured/appreciating quadrant, you should evaluate whether or not you really need to pay it off.
Many times you’ll be better off just carrying the debt until the loan matures because you can make more investing your cash instead.
For example, the interest rate on my mortgage is 3.5%. Currently, the interest rate on the short-term bond fund at my brokerage is 4.33%.
I’m, making 88 basis points more by just directing cash into a very low-risk investment instead of paying off my mortgage early.
Plus, if I ever need access to that cash, it will be much easier to liquidate the fund at my brokerage than it will be to liquidate part of my house.
In this case, clearly it makes more sense to just carry the debt.
Let’s talk more about evaluating whether to carry debts or pay them off.
Toxic Debt
If you’ve followed my channel or website for very long I hope you’ve seen The Next Dollar Roadmap, which is a 10-step plan for moving from negative or zero net worth to financial independence.
Milestone 3 on the roadmap is paying off toxic debt, which I define as debt that has highly destructive financial characteristics because it is either risky, has a high interest rate, or both.
The debt quadrants we just covered do a sufficient job explaining the risk factors associated with debt, but evaluating the interest rate is somewhat more nuanced.
There is a very simple, less surgical way to categorize “high” interest rates and a more complex, but more precise way to do it.
The simple way is to evaluate your interest rate relative to your age. Using this method, I consider an interest rate to be “high” if you are in your 20s and it is over 6%, if you’re in your 30s and it’s over 5%, or you’re in your 40s and it’s over 4%.
If you want a simple guideline to follow, this is sufficient, but I wouldn’t necessarily recommend focusing all of your energy on paying off your mortgage based on this method alone.
The more precise way to evaluate interest rates is more complicated because it moves.
Using this method, I would compare the interest rate on your debt to the current treasury yield for a T-bill or note of similar duration.
For example, let’s assume you have a car loan with an interest rate of 3.8% and there’s 24 months left on the loan.
As I’m writing this, a 2-year Treasury Note is selling with a yield of 4.26%.
That means I could go buy a 2-year Treasury Note and earn more interest with virtually no risk than I’ll save by paying off my car loan early.
It’s not a huge difference, but it provides a benchmark for the current cost of debt versus the interest rate you’re paying.
Since the car loan has a better rate than a low-risk bond, there isn’t an urgent need to pay it off early based on the interest rate alone, because you’re getting a great deal on the debt.
Of course, in order to come out better off financially, you’ll need to actually invest the money you would be using to pay off the debt.
Truthfully, this sort of evaluation is only valid if the ultimate choice you are making is between paying off debt or investing the money instead.
If you’re deciding between paying off debt and going to Tahiti, you can still go to Tahiti, but just know that it isn’t financially optimal (NTTAWWT).
My Two Cents
I’ve always had a very conservative point of view when it comes to debt. I’ve written all of this with the assumption that you, the reader, have various debts you want to pay off.
If I could have caught you earlier, I would have suggested that you avoid borrowing money for anything that won’t appreciate in value.
Arguably, mortgages and student loans are the only debts that fit this category for me (and I’d put some serious guardrails on those student loans).
I don’t even like borrowing money for cars, which I know is a bit unusual, but so are millionaires.
Ultimately, debt is a tool, but it can be a dangerous one. More often than not, I see it misused. When in doubt, use cash if you have a choice.
Another final thought is regarding mortgages.
You may have a mortgage that exceeds the “high” interest evaluation criteria I walked through earlier, but I wouldn’t necessarily pay off a mortgage based on that information alone.
The reason is mortgages take a lot of time and money to pay off. Building a nest egg takes a lot of time and money to build. These priorities are often in conflict with each other.
If you are choosing between paying off a mortgage with a relatively high interest rate and investing for retirement, I would lean toward investing.
In the meantime, I’d keep an eye on interest rates and refinance your mortgage to a lower rate when the opportunity presents itself.
Of course, there’s also a chance that you’re doing great financially, and you just really want the mortgage out of your life for good.
Assuming you have adequate financial resources for retirement, feel free to go ahead and pay it off if you want.
Summary
So, let’s summarize everything we’ve covered in a step-by-step list:
- Identify the debts that are toxic or severely hindering you financially using the debt quadrants and the “high” interest evaluation methods I shared earlier.
- Pay those debts off using either the debt avalanche or debt snowball method.
- Once your debts are gone, direct your extra cash toward investing for retirement (or jump over to Milestone 4 on The Next Dollar Roadmap and continue from there).
Thanks again for your interest in my content. God bless and take care!
