There are two different commonly used debt repayment strategies. The first is the Dave Ramsey “snowball” method, in which you focus your excess money on your debt with the lowest balance. Then, once that debt is paid off, you take the monthly payment you were making on the now-paid off debt, plus your excess money, and then focus on your next lowest balance debt, and so on. The second is the mathematically correct “avalanche” approach of paying off your highest after-tax interest rate debt first, even if it is your largest debt. Instead of comparing the balances of your debts to determine which one to pay off, you compare the interest rates of your debts, adjust the interest rates for the ones that are deductible (by reducing the comparable interest rate by a percent equal to your effective tax rate) and pay off the debt with the highest interest rate.

The snowball method is preferred by many because of the psychological benefits of successfully paying off a debt. If you focus on a high-balance debt like a mortgage, it can take 10 or more years of applying excess money to that debt before it disappears. If you instead focus on a credit card with a $5,000 balance, and pay it off in three months before applying the $100 monthly payment to your next debt, then you have one less bill to deal with and you get some emotional satisfaction from succeeding in getting rid of a debt.

The snowball method, however, is clearly inferior to the avalanche method. Assume that Doctor A and Doctor B both have a $300,000 mortgage at 5% interest, a $20,000 car payment at 3% interest and $25,000 in credit card debt at 15% interest. Both have $2,000 of money left over each month after all bills, including minimum payments on the debts, to pay towards the debts. With the snowball method, the total amount paid would be $421,393, whereas with the avalanche method, the total amount would be $418,771 (thanks to undebt.it for the calculations).

The approximately $2,600 difference between the two methods is not incredible. For this reason, if your situation is similar to the above and the debt snowball method will encourage you to stick to your debt repayment strategy, then by all means go for it. When interest rates are higher, as they have been in the past, then the avalanche method may be of greater value.

Each situation is different. Use undebt.it, or consult with your financial adviser, to work through the calculations and compare those options to your other choices of building a cash reserve and saving for retirement.

-Richard

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