Which debt should you pay off first?

By The Simple Dollar

I've been looking for a good real-world example to compare the traditional "debt snowball" approach to the approach of paying off the high-interest loan first above all. Recently, I received a note from a reader named Bryan:

I just graduated college this year and am starting a job where I'll make $47,000. I've got significant student debt, which I will try to pay off as much as I can the next couple years (while my responsibilities are minimal).

I have three loans: $5,000 at 3.75%, $11,000 at 6% and $40,000 at 8%. Which one do I focus on paying off first?

It seems like the largest one with the high interest. But I could "snowball" it and pay off the smaller ones (while paying minimum on the large one), and then use that money to hit the large one hard after the small ones are paid off.

What are your thoughts?

In order to see what the minimum payments would be on each loan, I headed over to Bankrate.com's amortization calculator. I assumed that each debt was for 10 years, so given that assumption, here are Bryan's minimum payments:

• The $5,000 debt has a minimum payment of $50.03 per month.

• The $11,000 debt has a minimum payment of $122.12 per month.

• The $40,000 debt has a minimum payment of $485.31 per month.

These debts total $657.46 a month.

Let's also assume Bryan is going to devote 25% of his pretax salary to taking care of this debt, $11,750 a year, or $979.17 a month.

The debt-snowball method

Using the traditional debt-snowball method, Bryan would focus on paying off the smallest debt first while making minimum payments on the rest.

The first debt:Bryan takes the $321.71 extra each month and applies it to the smallest debt. He would have this first debt paid off in 14 months.

The second debt:At the 14-month mark, Bryan takes the extra $371.74 each month and applies it to the $11,000 debt, which because he's been making the minimum payments, now has $10,029.12 to be repaid. He would have this second debt paid off at the 36-month mark.

The third debt: At the 36-month mark, Bryan takes the extra $493.86 each month and applies it to the $40,000 debt, which because he's been making the minimum payments, now has $31,137.16 to be repaid. He would have this third debt paid off in 72 months, or six years.

The highest-interest method

Using this method, Bryan would focus on paying off the highest-interest debt first while making minimum payments on the rest.

The first debt:Bryan takes the $321.71 extra each month and applies it to the highest-interest debt, the $40,000 debt. He would have this first debt paid off in 61 months.

The second debt:At the 61-month mark, Bryan takes the extra $807.02 each month and applies it to the next-highest-interest debt, the $11,000 debt, which because he's been making the minimum payments has only $6,226.32 to be repaid. He would have this second debt paid off at the 68-month mark.

The third debt:At the 68-month mark, Bryan takes the extra $929.14 each month and applies it to the remaining debt, which because he's been making the minimum payments has only $2,397.76 remaining to be paid. He would have this final debt paid off at the 71-month mark, one month short of six years.

Which method wins?

With either method, you've cut at least four years of payments. The highest-interest method obviously gets the debts paid slightly quicker, which means that Bryan would pay less in overall interest by going that route.

However, with that method, the "successes" don't start happening for more than five years. With the debt-snowball method, the successes occur more regularly through the process, meaning it's better for keeping your encouragement up as you repay.

For me, I would still go with the highest-interest method -- it simply puts more cash in your pocket in the end. I would also advise Bryan to never make more than the minimum payment on that 3.75% debt because he's cash ahead even if he simply puts that money in a high-yield savings account rather than making early payments on that one.

This article was written by Trent Hamm, the founder of The Simple Dollar, a blog offering a peek at his recovery from near-bankruptcy.

Published Aug. 8, 2007