In this article, we give an answer to the question: “How to pay off your debt faster? Which is better: to pay big or small debts?” based on the advice of the most famous personal finance experts, such as Dave Ramsey, in my own experience.
In personal finance management, only 20% knowledge and 80% behaviour are required.
We might be tempted to think of paying off the highest-interest debts first, however, statistically, the most effective way has been proven to be:
The snowball method, popularized by Dave Ramsey, author of the book “The Total Transformation of Your Money” recommends paying off debts in order of size, starting with the smallest, regardless of the interest rate. Make the minimum payment on all but the smallest balance.
What if I have large debts with a higher interest rate than small debts?
From a mathematical point of view, we should pay the higher-interest debts first, rather than the lower-interest debts. Truth be told, if we all based our decisions on math, no one would have debts.
If we all based our decisions on mathematics, no one would be in debt.
Therefore, the solution to a behavioral problem is a behavioral change, not a mathematical equation.
What we need is to see quick results. If you pay off the smallest debt quickly (you can do it precisely because it is small), you will see the total debt pile go down: First big win.
The most important thing about paying off the first small debt is the feeling of accomplishment.
You know that, if you managed to pay the first one, you will pay the second one, the third one…until the last one.
Another great advantage, more mathematical than the first one, is that you free up cash flow.
If for your smallest debt you were paying 50 euros a month, when you pay it off, you will have 50 euros (or dollars ) more each month to pay the next one. Second big win.
Isn’t it better to pay off the debt with the larger installment rather than the debt with the smaller installment?
It will take you longer to pay off the debt with the larger installments because it is most likely a larger debt.
Remember that what we need are early wins. If your first goal takes you 5 years to accomplish, after the first 6 months you may already be demoralized.
If it takes you 3 months to eradicate the first debt, by the fourth month you will have self-esteem higher than Donald Trump’s when he was elected president or Maradona’s when he scored the goal with his hand. 🙂
And you will use that burst of self-esteem to go after the second debt in size (probably another small one).
The smallest debts I owe are to my mother, who does not charge interest.
You should pay interest to your mother and your relatives. Personally, I would rather pay interest to them than to the bank. Back to the point, imagine you are a young boxer. You have to win fights to build up your record of victories.
When an 18-year-old boxer is just looking for his first fights, he doesn’t want to fight Tyson, Mayweather, or Muhammad Ali (or their modern equivalents). He must pick fights with opponents weaker and less well-trained than he is.
By “securing” early victories he will improve his self-esteem and will learn and prepare himself to face stronger, more skilled, and experienced opponents.
In our case, debt is our opponent. If you manage to win the debt battle with your mom and your Aunt Charito, you will be better prepared to destroy your bicycle or motorcycle debt.
When you have already defeated (paid off) the debts to your mom, to your Aunt, etc, and to the bike shop, you will be all set to pay off all your credit card debt (or the next one in order).
You’ll know how to allocate your surplus cash flow. You’ll know it’s possible, you’ll know how to leverage your surplus cash flow to pay large installments to reduce the amount of debt at an accelerated rate, and if necessary, you’ll be trained to negotiate so that you won’t be charged prepayment penalties.
No one can stop you. You will obliterate, erase, and unstoppably wipe out debt after debt. You will look like a locomotive approaching an ant walking on the rail: unstoppable.
Finally, you will be used to it. You will know that the normal, natural, and obvious thing to do is to use all the pile of free cash flow you have been building up by paying off debt faster after proceeding to the next one as quickly as possible.
What happens if I take on more debt than I can pay?
There will simply come a point where everything will collapse. When you start building the snowball to end all your debts the first commandment is: Don’t get into debt.
You will not use any more credit cards, and you will not ask your mom or your uncles, or your brothers for more money. Not one more.
If a contingency arises and I can no longer pay the installments, what should I do?
People who budget don’t have unforeseen events. It’s not that things don’t happen to them, they just foresee them. The heater is damaged: you have to budget for the useful life of the heater, the iron, and the vacuum cleaner. In addition, the maintenance of the car, the house, and even the bicycle is budgeted.
Important: insurance is taken out to prevent unforeseen events.
On the other hand, according to the snowball method described by Dave Ramsey, the first step of the debt eradication (snowball) method is to create a safety fund. This fund should be used only in emergencies.
By the way: a Shakira concert or a new iPhone do not fall into the category of emergencies.
The value of the emergency fund should be equivalent to your total expenses between 3 and 6 months.
In this article, you will find a description of the method to get out of debt.
What are the steps to should take, and in what order, to pay off your debt faster?
The following are the 7 steps of the method to regain control of your financial life, according to Dave Ramsey:
- Save $1,000 to start your emergency fund.
- Pay off all your debts, except for your home, using the snowball method.
- Save 3 to 6 months of expenses in a fully consolidated emergency fund
- Invest 15% of your annual income for your retirement
- Save to build a college fund to pay for your children’s college education
- Pay off your home mortgage debt early
- Build your wealth and donate
What if I have no debts?
If you are debt-free, congratulate yourself first and foremost. You can use all of your net income (after paying your expenses) to build equity that generates income in addition to your work.
Stay that way, debt-free.
Your family, friends, and neighbours probably have debt. Being debt-free is different from “normal” behaviour, but you don’t have to worry about it. Sometimes what most people do is not the best thing to do.
You will see that, when paying for a 10,000 EUR car, you pay 10,000 EUR, not 25,000 EUR like the one who pays for it with consumer credit. If you pay for the purchase for 100, you pay 100, not 300 like the one who pays with credit cards at 30% interest.
You are on the right track, keep it up!
Conclusion. Which is better: Paying off big debts or small debts?
Create a list of your debts with all the information of each one; organize it in order of balance from smallest to largest and start paying them in that order, because:
“It’s better to pay off small debts first and then the bigger ones.”
Organize your financial life by keeping a budget.Â
Build an emergency fund, initially of 1000 EUR or USD, etc; in the long run, it should be equivalent to 3 to 6 months of your household expenses.
Do not take on any more debts, big or small. Dispose of your credit cards completely.