Now for the crucial next step in your plan to Set a Course to Be Debt Free. Take your list of debts and arrange them in order, from highest interest rate to lowest interest rate. Now you have a list with the highest interest rate debts at the top of your list. That probably means that on your list your department store credit cards and payday loans are at the top of your list, and car loans and your mortgage are at the bottom of your list, since they carry the lowest interest rate. Why is this important?
A list of debts ordered by interest rate is important so that you can avoid the most common debt pay down mistake: paying small amount debts first, instead of paying high interest rate debts first. Here’s an example:
Joe has two debts: He owes $500 on a line of credit that has a low interest rate, and he owes $2,000 on his department store credit card with a high interest rate. Joe wants to become debt free, so he decides to concentrate on paying off his line of credit, so he only has one debt to worry about.
Sorry Joe, in most cases that’s the wrong decision. If you are paying 8% interest on your line of credit, and paying 24% interest on your department store credit card, every dollar you repay on your line of credit saves you 8 cents per year in interest; every dollar you repay on your credit card saves you 24 cents in interest. The proper strategy is obvious:
Yes, it’s nice to eliminate a small debt so you don’t have to worry about it, but if paying a small debt means you will pay three times as much interest on a higher interest rate debt, the prudent strategy is to pay off your high interest rate debts first.