The Harvard Business Review recently published a study on “the best strategy for paying off credit card debt.” Set aside for a moment the idea that you should try not to rack up credit card debt in the first place (shit happens, no judgment). This study benefits the millions of Americans who are literally $800 billion in collective credit card debt according to the Federal Reserve. So it’s a problem that needs a solution.
The researchers tested a couple of different methods for credit card debt reduction:
- Dispersing payments equally across every credit card each month.
- Concentrating as high a payment as possible on one account at a time.
One debt at a time
Their results showed that “people are more motivated to get out of debt not only by concentrating on one account but also by beginning with the smallest” (emphasis mine). In other words, if you have a balance on multiple credit cards, you need to throw all your efforts behind paying off the one with the smallest balance first.
You’ll be more likely to follow through until all your debt is gone if you use this strategy. That early sense of accomplishment you get from paying off the smallest debt first will make you feel capable of decimating even the largest debt. Succeeding at paying down debt, in other words, is all in your head.
A debtor’s sense of progress, according to the study, is based on their perception. They measure their personal success not by the size of the repayment or how little money is left on a debt. Rather, by “what portion of the balance they succeed in paying off.” And let’s face it: it’s a lot easier to pay off half of a $1,000 debt than half of a $10,000 debt.
This is called the Snowball Method, as popularized by the Voldemort of personal finance. Here’s more on debt from Dumbledore’s Army:
- Kill Your Debt Faster with the Death by a Thousand Cuts Technique
- Investing Deathmatch: Paying off Debt vs. Investing in the Stock Market
- Share My Horror: The World’s Worst Debt Visualization
- A Dungeonmaster’s Guide to Defeating Debt
- The Debt-Killing Power of Rounding up Bills
But the headline is misleading. What the study is really measuring is the method most likely to be successful, not necessarily the best method. The researchers ask, “What repayment strategy is most likely to motivate them to get them out of debt?”
They’ve figured out which tactic people are sure to stick with until their debt is eliminated. And sure, that’s one way to define “best,” but it’s not the only or even the most obvious definition. This makes it really about what motivates debtors to succeed, not what is most efficient and logical when it comes to paying down debt. It’s a study of people, not money.
So emotional gratification and continuous encouragement aside, what is the best method of paying down debt?
The Avalanche Method
Let’s say you’re a self-motivated and rational human being, a veritable cold-hearted logic machine. You won’t need to trick yourself into following through on debt reduction—you’ll just do it. You won’t need the early sense of victory that comes with paying down the smallest debt first. Instead, you’ll do the math and tackle the debt that will save you the most money when it’s eliminated.
This is called the Avalanche Method.
Don’t start with the smallest card balance. Start with the card that has the highest interest rate. Or if you have multiple cards with the same high interest rate, pay the one with the largest balance first. By paying it down soonest, you’ll get the most bang for your buck. You’ll save more in the long run by not allowing that high interest card to accrue any more evil interest.
The card with the highest interest rate might also have the lowest balance—and that’s fine! But it might also have the largest balance, or fall somewhere in the middle. Either way, your goal here should be to pay down your debt in a way that will have the biggest positive influence on your net worth.
The Snowball Method
One thing the HBR researchers and I agree on is that you should focus your efforts on one debt at a time. Besides the proof that working on one account at a time leads debtors to work harder to pay their debts more quickly, it just simplifies things. Knock out those debts one by one and you’ll feel totally concentrated and ready for the final boss battle against The Last Debt.
But I’d take this advice one step further. A tenet of Personal Finance 101 is the snowball method (similar to the Avalanche Method). Coined by Dave Ramsey (yes, he’s that guy), the Snowball Method means that every time you pay off a debt, you should roll the payment for that debt over into the next debt you have to pay. As you pay off debts, the total amount you’re paying every month stays the same while the total amount going toward the account you’re currently paying off increases exponentially.
I used the Snowball Method while paying down my student loans one at a time. It was incredibly gratifying, simple, and fast. Keeping with the video game metaphor, it literally feels like leveling up. Every time you kill a debt you’re able to face the next one with a bigger, stronger payment that does more damage.
So in conclusion:
- Pay down one debt at a time.
- Choose the Snowball or Avalanche method.
- Level up, you personal finance warrior you.