Which debt should I pay off first?

The financial sphere seems all abuzz with The Barefoot Investor‘s book. Multiple friends have asked me about it. It’s the number one non-fiction book at both my local library and bookstore. But as happy as I am to see a finance book so popular, is it really ‘the only money guide you’ll ever need’? Will following Scott Pape’s ‘domino’ advice (or Dave Ramsey’s ‘snowball’ advice for that matter) really help you get out of debt for example? The best way to pay off your debt is likely to be something else entirely…

Before I tell you what that is, consider the following scenario:

You are a fire chief, in charge of deploying three units to put out fires. There are three currently burning. One is a tiny piece of paper in the middle of a vacant car park, with no flammable material around, just smouldering. Another is an enormous, but empty, shed. And the third is a house fire, with an elderly man and his three small grandchildren trapped inside, raging violently.

What do you do?

  • a) Send all of your trucks to the fast-burning family home.
  • b) Send all of your trucks to the slow-burning empty shed.
  • c) Send all of your trucks to the smouldering piece of paper.
  • d) Send one truck to each fire.

Hold that thought.

Now, let’s take a look at what Pape is recommending.

In his section titled ‘Everything you wanted to know about paying off your debts – in one-and-a-bit pages’ Pape answers six important questions about debt. Most of these, I have no quibble with (for Australian readers at least – the appropriateness of these answers will differ wildly depending on where you are in the world):

  • Should I pay off my HECS-HELP debt? (I assume he means ‘early’ rather than ‘at all’): ‘No, it’ll look after itself’. (For those outside of Australia, a HECS-HELP debt is a loan from the government to cover tertiary education.)
  • What should I do about my car loan?: ‘Get rid of it.’
  • Should I worry about what’s on my credit file?: ‘Yes. But don’t get all freaked out about it.’
  • Dude, Visa has a hitman looking for me – should I go bankrupt: ‘I only recommend bankruptcy in the most extreme circumstances’ (a hitman would seem pretty extreme to me…)

But the other two, I have issues with. And these are not problems limited to Pape, but to many others of his ilk – writers of popular guides which, whilst easy-to-read, motivational, and entertaining, do not always dispense the best financial advice.

These questions and answers have to do with Pape’s ‘dominoing’ system, which is very similar to Dave Ramsey’s ‘snowballing’ system.

Essentially, the system works like this:

  1. List all of your debts.
  2. Order them from smallest to largest.
  3. Single out your smallest debt. Pay that off first.
  4. Move on to the next smallest debt.

Pape likens debt to a ‘financial fire’, and I think he has his metaphor right. As Mr. Money Mustache says, debt is an emergency, one which needs our immediate attention. However, I don’t think Pape or Ramsey have the method right.

Pape says

‘Use your Fire Extinguisher (20 per cent of your take-home pay) to ‘hose down’ your smallest debt.

Then turn the hose to the next debt, and the next, until they’re all put out.

But remember: while it’s great to put your spare money (Fire Extinguisher) into paying off your debts fast, always make the minimum repayments on all your debts (such as a monthly payment on your credit card) using your Daily Expenses money.’

Let’s think about this debt proposal, starting with the tools:

If you were a fire fighter, would you always use the same fire extinguisher for every fire? Regardless of its size, type, or intensity?

Or would you use a small electrical fire hand-held extinguisher to put out a fire in a computer? A large fire truck to put out a fire in a house? A plane to extinguish a bush fire?

Now, let’s take a look at the method:

If you were a fire chief in charge of fighting multiple fires, would you send ALL your crews to put out the SMALLEST and potentially least dangerous fire first? Just so you can feel good about there being one fire less?

Or would you look at which fire was burning the most intensively, that had the most potential to damage people and property, and which looked as if it might rage out of control, and allocate more of your resources to that?

My suggestion is that you be a smart fire chief when it comes to your finances too. Nobody will congratulate a fire chief who successfully extinguishes a burning piece of paper while a family perishes. Starting with the smallest debt does NOT make mathematical sense.

The single BEST way to pay off your debt quickly is to pay off the amount with the highest interest rate, NOT loan balance first.

Here’s why:

Imagine you have a few different debts – a home loan of $400,000 at 4.5% interest, a personal loan of $20,000 at 16.5%, and a car loan of $15,000 at 8.5%.

That’s a total of $435,000 in the red.

Scenario 1: The Snowball/Domino Method

According to the snowball/domino method, we should start with the lowest debt to get the ball rolling (or the dominoes falling) – the $15,000 car loan.

If your monthly take home pay is $5,000, then according to Pape’s method, you should devote 20% of this ($1,000) to ‘hosing off’ your debt.

Year 01: Car Loan

Starting with the smallest debt – the car loan – you make the minimum payments of around $215, plus the extra payments of $1,000 (whilst still making the minimum payments on your other debts).

At the end of year one, there’s just a little over $2,300 remaining on your car loan. The end is in sight!

After the minimum payments on your other loans, your total debt is now $413,048.66 – a reduction of almost $22,000! Without the extra payments, you’d still owe over $424,000.

Year 02: Personal Loan

In February, you make the final payment on your car loan. The balance is now so tiny, you don’t even need to use the whole $1,000 you’ve set aside for extra payments. You throw the remainder at the next smallest loan – the personal loan – instead. Now, instead of having three outstanding debts, you only have two to tackle. Feels great, doesn’t it?!

By the end of the year, not only have you eliminated your car loan, but there’s only a little more than $6,500 left on your personal loan. Incredible!

After the minimum payments on your home loan, your total debt is now down to $389,221.49 – you’ve broken the $400k mark and then some!

Year 03 onwards: The Home Stretch

In May, you make the final payment on your personal loan, and once again, you have money left over to throw at what is now your only debt remaining – the home loan.

At the end of the year, your debt is just $365,872.56.

Continuing to make $1,000 extra payments each month like clockwork, you eventually pay off your final debt in May of year 16. Nine and a half years ahead of schedule. Woo-hoo!

BUT

Even though this is a great saving, there is a much better way to do it.

Let’s see what happens when you put out the most intensely burning fire that has the most potential to do damage (i.e. the one with the biggest interest rate) first:

Scenario 2: A Better Method

Year 01: Personal loan

Your personal loan’s interest rate of 16.5% almost twice as much as your car loan, and almost four times as high as your home loan. It is obviously the most urgent fire.

Let’s start off by attacking that loan first.

At the end of year one, there’s just a little over $7,000 remaining on your personal loan. Not quite as motivating as the much smaller sum remaining if you’d tackled the car loan instead, but let’s take a look at your overall situation now:

After the minimum payments on your other loans, your total debt is now $412,658.29. That’s almost $400 less than if you followed the snowball or domino method.

Sure, $400 might not be much. But over time, it adds up to a lot.

And the brilliant thing?

You haven’t paid a cent more.

In both scenarios, you devoted the exact same amount – the minimum payments on all three loans plus $1000 extra per month.

That difference is what happens when you focus on extinguishing the debt fire which is costing you the most first.

Year 02: Car Loan

In June, you make the final skerrick of a payment on your personal loan, and throw the rest onto your car loan. It’s taken a little while longer – four months, to be exact- but now you have only two debts left too.

By the end of the year, not only have you eliminated your personal loan, but there’s only a little more than $5,100 left on your car loan.

Let’s compare the two scenarios here. The amount owing on your home loan is the same in either case, so let’s focus in on non-housing debt: using the domino/snowball method, at the end of year two you would have one non-housing loan, with just over $6,500 remaining. With this method, you also have just one non-housing loan, with just over $5,100 remaining. That’s an almost $1,400 difference. Enough to make an entire extra extra payment – and then some.

Year 03 onwards: The Home Stretch

In May, you make the final payment on your car loan, throwing the rest of your money on your final remaining debt  – your home loan. Despite the slower start in terms of knocking down debts (but the much faster repayment of the debt in dollar terms) you’ve now caught up.

At the end of the year, your debt is just $365,101.89. Over $700 less than if you’d gone with the domino/snowball method.

Continuing to make $1,000 extra payments each month like clockwork, you eventually pay off your final debt in April of year 16. You don’t even need to use the whole $1,000, pocketing a sweet  $860 for yourself.

Scenario 1 sees you paying $168,709.03 in interest over the 16 and a bit years.

Scenario 2 sees you paying $166,464.09 over a slightly shorter period of time, or around $2,245 less.

Sure, maybe that’s not exactly the big bang you were waiting for. But wouldn’t you prefer that two grand to line your pocket, instead of the bank’s?

But wait… there’s more!

Of course, it’s not just the method I have quibbles with, if you remember, but the tools.

Just like retirement planning, there is no one percentage that will be applicable for everyone when it comes to debt reduction. Someone with a lot of debt, but with low living expenses and a lot of income, would be a fool to restrict themselves to a 20% ‘fire extinguisher’. Others may struggle to scrape up that amount.

Suffice it to say that if you devote more of your income to paying off debt than the somewhat arbitrary 20%, it will disappear faster. This is hardly news. However, let us take a look at another missed opportunity in the scenario above: the minimum payments.

Imagine if every time you paid off a loan you added the amount you used to pay to that debt as a minimum payment to your ‘extra’ payments on the next loan. After all, if you were a fire chief with a crew who had just finished putting out one fire, but there were still other fires raging, wouldn’t you ask them to help out? (Bear in mind that money is infatiguable and not subject to work regulations!)

Scenario 2.1… a better method with better tools!

Let’s take a look at what happens in this enhanced scenario, following the payment of the first loan:

Year 02: Car Loan

Once again, in June of the second year, you pay off your personal loan. But this time, you add the minimum payment you used to make to your arsenal. This brings your extra payment for the car loan up to  $1,376.48.

This time, by the end of the second year, there is a minuscule $2,500 remaining on your non-housing debt (compared to $6,500 and $5,100 in the other scenarios).

Year 03 and beyond: The Home Stretch

Thanks to your increased payments, this time, you eliminate all non-housing debt by the end of February – several months earlier than the other scenarios.

You add the money you used to devote to paying the minimum payment for your car loan to the minimum payment for your personal loan, plus the original extra payment, for a new total of $1,592.36.

By the end of the year, your total debt is $358,576.48 (compared to $365,872.56 or $365,101.89 in the other scenarios – approximately $7,000 less debt).

Continuing to make $1,592.36 extra payments each month like clockwork, you eventually pay off your final debt in the beginning of August in year 12, with over $1,200 to spare.

Not only have you cut the total period of your indebtedness by four years in comparison with the previous scenarioes (and imagine what you could do with a spare $3,815.69 per month for those four years!) but you’ve effectively slashed the bank’s time line by half.

To recap:

Scenario 1 sees you paying $168,709.03 in interest over the 16 and a bit years.

Scenario 2 sees you paying $166,464.09 over a slightly shorter period of time, or around $2,245 less.

While the enhanced Scenario 2 sees you paying $138,049 over just 12 and a bit years – that’s a colossal $30,000 less.

To consolidate, or not to consolidate…

Now, the other bit I have a quibble with is Pape’s lukewarm advice regarding consolidation. Regarding whether you should your debts, he says:

“Maybe, but if you do, just make sure you only do it through a bank or a credit union (I don’t disagree with this at all)… And understand it’s not a magic wand. What’s keeping you from paying off your debts once and for all is your pattern of spending money. The people who ditch their debts for good have one thing in common: they change their attitude”

This is where I begin to have issues. Attitude is certainly important – I’ve talked a lot on Enrichmentality about the importance of how we approach money – that’s why this site has ‘mentality’ in the name. But it’s not just about attitude. It’s also about action. Including making smart money decisions.

Not everyone in debt is there because of frivolous spending habits or bad decisions. It isn’t always ‘your pattern of spending money’ that is the problem. Sometimes people have sick kids. Lose their job. A partner dies. A house that needs repairing. A car that breaks down. Bad stuff happens. It’s not all jetskis and caviar and handbags.

Assess your unnecessary spending

If you are in debt, it is important that you assess your unnecessary spending. And I mean everything. Do you go out to the movies or have a paid TV or streaming service? That’s unnecessary. Make use of your local library and watch free-to-air and YouTube. Chances are you’ll learn more. Do you go out for coffee? That’s unnecessary. Making your own costs next to nothing. Do you drink soda? That’s unnecessary. Water from the tap is much better for you, and almost free. Do you buy fancy brands of anything? There’s plenty of time for brand names later once you don’t have a raging fire of debt to put out.

By all means, do these things. Cut out everything that is unnecessary and watch your debt melt away.

But if you are really struggling, there’s no sense not consolidating your debts just out of principle. Punishing yourself with higher than necessary interest rates isn’t going to make your debt go away any faster. Debt consolidation isn’t for everyone – you may not be eligible, or the fees and charges may make it not worthwhile. But you shouldn’t rule it out.

So if it’s not the best method, why do Pape and Ramsey

recommend it?

I suspect the reason Pape cautions against consolidation has to do with the fact that his system simply wouldn’t work without multiple debts. It’s based on the motivation you can attain by kicking each one to the dust. If you have one big debt, it’s going to take a long time until you get rid of it completely.

Which means that it’s not going to be great advice for anyone who has already consolidated, or anyone who has only one debt already.

It also likely has to do with bringing about some change in you – getting you to face the consequences of your past spending. (At the expense of paying higher interest than necessary).

In theory, the debt-snowball method is motivational. The fewer creditors you have chasing you, the less stressed you feel. Each time you see a ‘balance paid off in full’ notification, the more accomplishment you feel. Research even suggests that debt-snowballing is the way people tend to deal with debt naturally – even without having read any ‘financial advice’.

But that same research shows that those who use debt-snowballing, for all the reasons I’ve outlined above, end up with worse financial outcomes than those who use the method I’m suggesting.

If you’re tempted to follow Pape or Ramsey’s recommendations when it comes to debt, remember, there’s a reason it’s called the ‘debt snowball’ method. Instead of making your debts smaller, it may well make them bigger if you have high-interest loans from unscrupulous or payday lenders with low minimum payments.

What should I do?

Ultimately, what matters is not how many debts you have, but how much debt you have.

I would much rather have three debts totaling $5,000 than ‘just’ one debt of $10,000.

Pape and Ramsey’s advice is attractive in its naturalness (as research shows, we don’t even need to buy a fancy book to figure it out – it’s how we tend to pay off debt without any guidance) and its simplicity. It fits on a bit over a page.

If you’ve had the patience to follow this 3,000 word explanation, I suspect you’ve probably got what it takes to use the method I propose above, which will see you out of debt faster and save more money – 4 years and $30,000 in this example. But remember, this method works for all debts. The shortest method is always to pay the highest interest rate first.

Switch your focus from the number of debts you have to how many dollars you owe.

On the other hand, if you’ve found yourself drifting off, getting bored or not following, maybe this isn’t the right method for you. Of course, it could just be my rambling!

Pape’s and Ramsey’s advice may not be the BEST method available to get rid of your debt, and as research suggests, may keep you in debt longer than necessary. However, it IS better than nothing.

I would recommend it if:

  1. You have already given the other, better method a go and found you lack the will power to keep going.
  2. AND you have investigated consolidation and found it’s not for you.
    OR you have lots of small debts that you can knock over quickly to build psychological momentum.

Both Pape and Ramsey are writing for a popular audience, targeting the ‘typical’ person who – as we know – tends to lack willpower when it comes to spending and saving. They also make assumptions about how much money the ‘typical’ reader has at their disposal which may or may not match your reality.

In my opinion, it’s even more important for those of us who don’t have giant salaries to make smart financial decisions. Those with higher incomes can better afford to pay off their debts inefficiently. But ultimately, all of us should want to put our money to work in the most effective ways possible.

For more information on choosing the right kind of resources and advice for you, check out my post on what it means to be financially typical.

Which method will

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