There are two popular methods that people use to pay off debt. The traditional method is called "debt stacking," while the latest craze is called the "debt snowball" and is recommended by popular financial expert Dave Ramsey. Let's take a look at the pro's and con's of each.
The "debt stacking" method recommends that you make a list of all your debts, ranked by interest rate, from highest to lowest. For example, you might owe:
- Mastercard - $2,500 - 19 percent - Highest Interest Rate
- Visa - $7,500 - 13 percent - Second-Highest Interest Rate
- Car Loan - $4,000 - 8 percent - Third-Highest Interest Rate
- Student Loan - $1,900 - 5 percent - Lowest Interest Rate
The "debt stacking" method advises that you make the minimum payment on all your loans. Then, you should throw all your extra money towards paying off your MasterCard, which has the highest interest rate, at 19 percent.
Once you've wiped away your 19 percent MasterCard debt, tackle the Visa balance, which has the second-highest interest rate, at 13 percent.
It'll take you a long time to repay the Visa, since it has the highest balance, at $7,500. Stick with it. Whenever you're done, you can start tending to the debts with lower interest rates.
Pros: This method saves you the most money in interest payments.
Cons: It might take a long time to get a high-balance debt crossed off your list. You may feel frustrated after investing so much time and energy towards getting paying down a loan, without feeling the mental "victory" of crossing it off your list.
According to the snowball method, you should throw every spare penny towards paying off the loan with the lowest balance, regardless of interest rate.
If you used the snowball method, you would re-order the above list as follows:
- Student Loan - $1,900 - 5 percent - Lowest Balance
- Mastercard - $2,500 - 19 percent - Second-Lowest Balance
- Car Loan - $4,000 - 8 percent - Third-Lowest Balance
- Visa - $7,500 - 13 percent - Highest Balance
You'd make the minimum payment on all your loans. Then, you'd throw every extra penny towards the debt with the smallest balance, regardless of the fact that - in this particular case -- it ALSO has the lowest interest rate.
The idea behind this method is that paying off the loan with the smallest balance will give you the psychological feeling of "victory" when you cross that loan off your list. That mental "win" will motivate you to continue saving money and repaying your debts.
Pros: This method gives you a more immediate feeling of victory.
Cons: It costs more. You'll pay more in interest, as compared to the debt stacking method.
Which Method Should You Use?
I like to say that personal finance is ... well ... personal.
Paying off debt is a little like dieting. Sure, there are more "ideal" eating plans out there, but let's be realistic: most people aren't going to stick to a perfect diet. The "best" diet is the one that you'll stick to.
Paying off debt is similar. Be honest about making a budget that fits your personality and keeps you motivated. You'll pay the most in interest if you don't stick with your debt payoff plan.