As it turns out, there are three popular methods: the “traditional” method, the “snowball” method, and the “annoying” method. Let’s look at the pro’s and con’s for these popular debt payoff techniques, so that you can decide which one is best for you.
Traditional Payoff Method
Under the traditional model, a person would first make a list of all of their debts, from highest-interest-rate to lowest-interest rate. For example, you might list:
* Mastercard, $12,000 balance, 14 percent APR
* Student Loan, $32,000 balance, 8 percent APR
* Car Loan, $3,500 balance, 3 percent APR
* Loan from Brother, $5,000 balance, 0 percent APR
A person would make the minimum required payments on all of the above loans, and then use additional money to pay off these loans in the order listed above, from highest-interest to lowest-interest. In theory, this saves the most in interest payments over the life of the loan, and mathematically, this strategy makes the most sense.
Snowball Method
However, another popular method coined by Dave Ramsey advocates ordering your debts based on balance, rather than interest rate. For example:
*Car Loan, $3,500 balance, 3 percent APR
*Loan from Brother, $5,000 balance, 0 percent APR
*Mastercard, $12,000 balance, 14 percent APR
*Student Loan, $32,000 balance, 8 percent APR
A person would then pay off the smallest-balance-loan first. They’d feel the mental thrill of victory when they got rid of that debt. Then they’d pay off the next, and then the next. Mathematically, this doesn’t make as much sense, since the person would be paying off lower-interest debts first. But mentally, this could help motivate a person to keep going.
Annoying Method
As another option, a person might order their debts based on “most annoying to least annoying.” For example, perhaps that loan from your brother really bothers you and keeps you awake at night, while your student loan doesn’t bother you at all. Or, perhaps the tables are reversed: your student loan bugs you, while the loan from your brother doesn’t.
In this third option, you’d pay off the most annoying loan first, before moving onto the next. This option ignores both the balance and the interest rate, and purely focuses on the psychological impact of the loan.
What’s the Best?
Which of these is the best option? There’s no single right answer. There are some people who fervently believe that paying off loans based on anything other than the interest rate is a sub-optimal idea, and there are others who say that they’ve tried and tried to pay off their loans through a variety of methods, and found that the snowball method works best.
This might be hard to hear — many people want a solid answer — but there’s also a certain liberation that comes from the knowledge that you can pay off your debts in any order that you’d like. Pick whichever route works best for you, and stick with it. The most important detail is that you’re paying off your debt, regardless of the strategy that you prefer.
source: lifeandmyfinances.com
