In this article:
When you're responsibly tackling your debt, it may be unclear which payoff strategy is best—especially if you've got several accounts of varying amounts and interest rates.
In general, prioritizing the debt with the highest interest rate will save you more money and allow you to redirect funds to other financial goals faster. But in some cases, it could make sense to pay off the debt with the highest balance first. That's especially true if you're planning to apply for a loan soon, such as a mortgage, and you'd benefit from lowering your credit utilization by paying down credit card balances.
Consider Paying Credit Cards With the Highest Interest First
You'll typically save the most money if you get rid of high interest debt as quickly as possible. The longer interest accrues on a balance, the more you'll pay. Compound interest makes this even more of a challenge because it means you'll pay interest charges on top of your existing accrued interest each month.
Prioritizing debt payoff based on interest rate is called the debt avalanche method. To begin, make a list of each of your debts, including their current balances, minimum monthly payments and interest rates, and sort them in order of interest rate.
Make the minimum payment on each debt so that you never fall behind, but put as much money as possible toward the debt with the highest rate. Once you pay it off, you'll no longer have to make that minimum monthly payment, so you'll apply that amount to the next debt on the list.
Here's an example. Let's say you have four debts:
- A student loan of $4,000 at 7%
- A credit card balance of $3,000 at 20%
- A second credit card balance of $6,000 at 18%
- A personal loan of $5,000 at 12%
Using the debt avalanche method, you attack the credit card with the 20% interest rate first, even though it has the smallest balance. If your minimum payment on that card was $120 per month, you'd pay extra toward it until it's gone.
You'd then apply that $120 to the credit card balance with the interest rate of 18%. Once that debt is paid off, prioritize the personal loan next, applying to it the minimum payment of $240 from your second credit card. In the meantime, your student loan at 7% would continue to accrue interest until it's paid off—but not as much as your higher-rate debts would have.
How Paying Off the Highest-Balance Debt Works
In some situations, though, paying off the debt with the highest balance may make the most sense.
For instance, perhaps you're focusing on debt payoff because you're hoping to qualify for a mortgage or other loan in the near future. Reducing your balances fast and limiting your credit utilization could become your top priority, rather than saving money on interest. In that case, you'd attack the highest balance rather than the debt with the highest rate.
Here's why: Credit utilization is the amount of debt you carry when compared with your credit limit. It's the second most important factor in your credit score after payment history, which means it can have a significant impact on whether you'll get approved for a loan in the future.
Experts recommend keeping your credit utilization to 30% or less at all times, but the lower, the better. So, if your credit limit is $10,000 on the card with a $6,000 balance, for instance, your credit utilization rate would be 60%. To qualify for a mortgage, your best bet would be to pay down that balance ASAP and get your credit utilization below 30%.
At the same time, your credit limit might be far higher on the card with the highest balance, meaning your credit utilization rate could be minimal. Take a look at all your cards' limits and focus on bringing down the balance on the card that's closest to its max.
Another time when paying off a high balance could be best? If your highest-balance debt carries a promotional interest rate for a certain period of time. Prioritize paying off that debt before the card's standard interest rate kicks in.
How to Choose a Payoff Strategy
Paying down debt won't happen overnight, which means keeping yourself motivated should also be a consideration while choosing an approach.
If you think you'll enjoy making a dent in the biggest balance, that may keep you excited about continuing the payoff process—which, in turn, will make you more likely to reach your goal of debt freedom. Weigh the importance of saving money on interest with your likelihood of staying enthusiastic along the way. The best strategy is the one that is more likely to help you get your debt balances to zero.