Okay, you’ve set up your budget and worked incredibly hard to produce one to two thousand dollars in an emergency fund which you have marked DO NOT TOUCH. You’re ready to move on to the next budgeting basic — paying off debt. Let’s face it, the reason many folks look to create a budget is to get a visual picture of their financial situation. In numerous cases, once they input the numbers into a spreadsheet or accounting program they find a less-than-agreeable monetary environment.
Creation of a budget allows individuals to put their debts into perspective and put a plan in place to knock them out. It may require extra work or selling unused or expensive items to pay down the debt, and it may take years instead of months, but it’s a project which can be accomplished. The question posed by many newcomers to the debt payoff process is:
Why should you pay the smallest debt first?
This is a logical question, because there are other factors to consider. Some people feel it’s better to first pay off debts with high interest rates. Credit cards or student loans are a prime example of this. Others may feel it’s better to start paying off the biggest debts first and work down to the smallest.
Let’s put it in perspective. Say you’re in charge of painting the interior of a home. Would you start on the biggest space and work your way down? It’s certainly doable, and yet, by the time you were done painting the large space there’s a good chance you’d be tired and not be able to paint the smaller ones.
The same perspective can be used in paying off debt. You can certainly start by paying off the largest amount owed but it will take longer to do so. In the meantime you’ll still need to pay the smaller debts, thus leaving you with little or no extra cash to apply to the large debt. The same can be said for paying off high-interest loans. You can start paying these off first. The downside is the large interest payments will significantly cut down the amount of actual debt paid off.
This is why financial experts suggest paying off the smallest debts first. Not only does it hypothetically take less time to do so but the money which is freed up by eliminating the debt can be applied to the next largest amount along with the regular payment. And as the debts continue to be knocked off your ledger, the amount of money applied to each increases. By the time the last and largest debt is reached, the pool of available funds is large enough to knock it out in a short period of time.