When it comes to paying off debt, there are various opinions of how to do it. Financial expert Dave Ramsey is famous for his advice of paying off debt on the account with the smallest balance, while expert Suze Orman suggests paying off debt on a highest-interest account first. Who's right? It depends.
Start with snowballing. The “snowball” method of paying off debt is simple. First, set an amount of money you'll put toward your non-mortgage debt. This amount must satisfy the minimum payments due each month but often includes an amount greater than the minimum payment. Stick to making those minimum required payments each billing cycle. Those required payments will decrease as you pay off the debt.
With the snowball effect, you continue to make the same overall payment to your outstanding debts, and your payments remain constant even as your minimum required payment shrinks.
Now the question is which debt should you apply the extra cash to each month? There are several approaches to consider.
The math method. If you behave financially more on numbers than on emotions, you should apply any extra cash to the debt with the highest interest rate. You'll save on total interest paid by knocking out the worst interest-accruing culprits first. This approach is particularly useful if it's going to take years to pay off your debts, as the interest rates will have a substantial impact on your finances.
However, if your interest rates across various accounts are relatively low – or hover right around the same annual percentage rate, even if they're all high – this method may not be the best approach.
The psychology method. Even if you think the math method is right for you, there's something to be said for the psychology method, which entails paying off your smallest debts first. The theory behind this option is that paying off small debts in full gives you a victory that helps keep you going.
If you're feeling overwhelmed by the number of bills with debt you receive each month, starting by paying off the smallest debt may make the most sense. Also, if you can focus enough to pay off your debts in a relatively short amount of time, the higher interest rates on other accounts may not add up to much extra money.
Two other considerations. While the two approaches outlined above are the most popular, two factors to keep in mind are liquidity and credit. As you work to pay off your debt, consider how you'll handle emergencies. While an emergency fund is the best approach, many people mistakenly rely on credit as a source of emergency spending, which only adds to their debt.
If your credit score is a concern, tackling credit card debt that has come close to or reached the card's credit limit may give your score a boost, as your debt utilization ratio – the amount of debt you have compared to the amount of available credit you have – is a key factor in how credit bureaus determine your credit score.