A common topic of conversation with my financial clients is which debt to pay off first. Some strongly prefer the Dave Ramsey “snowball” method of paying off lower balances first and then using the money saved from paying off the first debt to help pay off the second smallest balance, etc.  Others prefer to pay off their highest after-tax interest rate debt first, regardless of the size of the debt.

Let’s assume that the hypothetical client has three debts: 1) student loans of $100,000 at 4.5% interest, payable over 20 years; 2) mortgage of $300,000 at 5% interest, payable over 30 years; and 3) car loan of $40,000 at 2% interest, payable over 5 years.  The hypothetical client’s effective tax rate is 25%, but he makes too much money to deduct his student loan interest.

The first thing to do it to take all of these interest rates and adjust for whether the interest can be deducted.  In this case, only the mortgage interest is deductible.  As a result, its effective interest rate is reduced by a percentage amount equal to the tax rate, meaning that instead of 5%, the rate for comparison to non-deductible interest rates is 3.75%.  Under the theory of paying off the highest interest debts first, the student loans would be paid off before the mortgage, and the car loan is last.

If just the minimum monthly payments were made over the life of the three loans, and then as debts were paid off that extra monthly payment were applied to the highest interest debt that still remained, then the client would have paid $228,038 of interest on $440,000 of debt.  If the client has $500 extra dollars each month to apply towards one of these debts, and chooses to pay off the highest interest rate debt first, working his way to the lowest interest rate debt last, then the client would have paid $171,967 of interest, for a savings of $56,071.  If the client instead chooses to apply the $500 per month to the car loan first because it is the smallest balance and then the student loans, then the client would have paid $178,050 of interest, meaning that by paying off the debt in the less-optimal order, the client cost himself $6,083 of interest.

That is not to say that it is a terrible mistake to focus on the small balance debts first.  For many people, the confidence and psychological boost that comes from paying off any debt greatly increases the chance that he or she will continue with aggressive debt repayment and succeed in getting out of debt.  If paying off that car loan early with the extra $500 per month increases your chances of paying off your debt, then it is probably worth the extra interest paid over the long run.  Right now, with interest rates so low, it is less costly to focus on the small balance, lower interest rate balances first.  If that mortgage were at 8% interest, for example, then the cost (in terms of additional interest paid) of focusing on the smaller balance, lower interest debts first would be closer to $36,000 than $6,000.

So while I do not believe that the Dave Ramsey “snowball” method is optimal, for many people the increased odds of success will outweigh the additional interest paid, especially if the interest rates are low.

-Richard

Disclaimer