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A Better Way to Pay off Debt

As we have mentioned before, it is far better to get financial advice from a CERTIFIED FINANCIAL PLANNER™ professional than a financial entertainer on TV or the radio. A licensed financial planner can help you address issues such as the demise of the 4 percent rule (something that everyone saving for retirement needs to understand) and the optimal to apply for Social Security benefits based on your age, marital status and desired retirement income. But when someone refers to buzzwords such as the “baby steps” they are taking to pay down their “debt snowball,” it is immediately apparent that they take the word of financial entertainers as gospel – and unfortunately, that means they are acting on bad information. While we’re on the matter of the so-called debt snowball, let’s talk about why that might not be the best strategy for getting out of debt.

Here’s how the debt snowball method works: First, you make a list of all your non-real estate debt – everything but your house payment. Then, you organize your debt according to the balance of each account (smallest to largest). Next, you start paying off the debts by paying the debt with the lowest balance first. You pay them off one by one, from smallest to largest, with no regard for the interest rates on any of the accounts. It sounds like a good practice and it motivates a lot of people, but it has a few problems – and to be honest, it may not be the fastest way to pay off your debts.

That’s right: Just as the 4 percent rule may not be the best way to live on your retirement income, the debt snowball may not be the fastest way to get out of debt. Rather than paying the account with the lowest balance first, consider paying on the account with the highest interest rate first. That’s not a pitch for a new “system” – it’s just mathematical fact.

Here’s a hypothetical illustration. Account A has a balance of $9,000; Account B has a balance of $29,000. Account A has the lower interest rate – say, 15 percent. Account B has the higher interest rate of 21 percent. Using the debt snowball method, you would pay down Account A first because it has the lower of the two balances. It makes you feel good, of course, because you’re getting your first debt paid off and that can be very motivating. Unfortunately, this motivation comes at a cost. Making the minimum payment on the account with the lowest balance, while ignoring your higher interest account with a higher balance, is going to cost you money.

Using the figures above for Account A and Account B, you would end up paying $2,980 more in interest if you chose to pay the lower balance, lower interest account first. Was the motivation you got from paying the lower debt first worth that amount? You can do a lot with $2,980; many people can make two house payments with that much money. And if you make the minimum payment on Account B every single month, then you can actually pay it down four months faster than you would by making the minimum payment on Account A. That’s because you are attacking the account with the higher interest rate, so less interest is accruing.

Now, that’s not to say there is no merit in the debt snowball method. For some people, sustaining momentum to pay off a higher account balance may be quite difficult. Regardless, that’s what anyone who truly wants to pay off their debts quickly should consider doing. According to prudent financial planners, it is a sound alternative because it saves you money and takes you less time. Why wouldn’t you want to do something that offers those benefits?

Once you have paid off your debts, you can turn to the next step: planning for retirement. A licensed financial planner can explain everything you need to know about building retirement income streams, including which actuarial assets to choose and how much you can sustainably withdraw for your living expenses (now that the 4 percent rule is obsolete).

All numeric examples and any individuals shown are hypothetical and were used for explanatory purposes only. Actual results may vary.