So there seem to be two prevailing ideas about how to pay off loans/credit cards/etc. Highest interest rate first, which is self-explanatory, and the snowball approach, in which you pay off the smallest loan first and go upward from there.
The appeal of the latter option is that it is psychologically more satisfying. Smaller loans seem easier to tackle and provide more immediate gratification once paid off. But I have heard different people say this doesn’t make sense because you could have a much higher interest rate on a larger loan (which is all around worse) that sits around while you pay down smaller loans just because they are smaller. I agree that it doesn’t make sense.
The whole point of accelerated payoff is to avoid paying interest that would otherwise have accrued. With zero percent interest rates (given a market like ours now in which money in the bank doesn’t really make interest either), there would be no advantage to early payoff other than not being in debt.
But the thing that bothers me about “highest interest rate first” is that this does not necessarily mean most interest paid in reality. Say you have a $1,000 debt at 8% interest rate, which would generate $80 interest in a year. And say you also have a $10,000 loan at 2% interest rate that generates $200 interest in a year. I would rather pay down the low 2% loan because it is generating overall more interest due to the higher balance. (With targeted accelerated payments the larger, lower interest rate loan would at some point reduce to accruing the same amount of interest as the higher interest rate loan – probably around $3600.) At that point I would want to switch back to paying the higher interest rate loan.
So why aren’t people talking about “highest amount of interest accrued” rather than “highest interest rate”? Just easier to define?
Whoops, I was wrong. Someone pointed out that even in this edge case, an extra payment of any amount would go straight to principal and make a bigger impact on the smaller loan than the larger loan. Since the smaller loan in this case also has the higher interest rate, the reduction in the principal would also have a bigger impact on the amount of interest generated going forward. Overall bigger impact. This is why everyone talks about highest interest rate first. Good to know! Thank you, anonymous reader of my blog…