There are many different types of debts: credit cards, personal loans, bank loans, business loans, etc. Some of them have very high interest rates (18%, 19%, 20%, oh my!) And often, they are using all of them for their business.
The common question always is, shouldn’t I pay off the highest interest rate loans first?
Debt and Human Behavior
Logic dictates that we should pay off the high-interest loans first. But, there are a few factors of human behavior to consider.
Humans don’t always follow the logical thing.
Humans don’t celebrate the early successes we experience.
You see, humans love to have everything. And they love to celebrate. Sometimes that isn’t a good combination if you already have a lot of business debt.
But, every little win is important. It’s been scientifically proven. Even if it’s something simple like checking a box off on your to-do list, you get a little bit of a rush and a happy feeling.
So what does that have to do with Debt?
The Snowball Effect
The snowball effect is the methodology that you pay the debts with the lowest balance first, instead of the traditional way of paying the highest interest rate first.
It builds up a series of early successes as more and more money is freed up to target the remaining amounts of your debts. Those wins at the beginning will create massive momentum to change how you think about and use your money.
First, list all of your debts from the largest amount to the smallest amount. Don’t worry about the interest rate. If you want to note it in the next column as a reference, you may do so.
Next, start paying your debts! All of your financial efforts should be put into eradicating and paying off the smallest debt on your list. You will continue to pay the minimum balance on all of the other debts.
Once you have eradicated the first small debt, you celebrate! This is a big step you have taken to pay off a debt, no matter how small!
Then, you’ll target the next smallest debt on your list. You’ll take the amount of money you were paying on the smallest one and add it to the minimum balance of the next debt and start paying that off.
Then when that debt has been paid off, you work on the next one.
When you choose to pay off the lowest balance first (not the highest interest rate), then that early progress in managing money and debt helps us become committed to the process even if the progress is really, really small (like a balance) and not really big (like an interest rate).
And when you celebrate those little victories, you’ll be amazed at how much you have done to eliminate your debt. I’ve had clients that have attempted to pay off the highest interest rates first, but the quick win doesn’t come, and they get discouraged. So there is a clear methodology that comes from starting with the smallest balance first.
The Snowball Effect and Profit First
Dave Ramsey, author of Total Money Makeover, suggests using The Snowball Effect in conjunction with the Profit First methods.
When you are in the habit of Profit First, celebrating your successes, and setting aside money in your profit account, you are training your mind and altering your human behavior.
Most business owners look at their bank account balance when trying to make a big decision and see what's in there. They aren’t tracking their expenses, setting aside money for taxes, or paying themselves well. It’s so important to understand what the money in your business is actually doing. That is where the Profit First system can help because it helps you know your expenses and how you’re operating.
Your operating expenses help you to leverage and take advantage of your human behavior. Dave Ramsey says, “One of your biggest resources in building wealth is your income.” So when you have debt payments, it’s eating away at your income. You want to get rid of that debt as quickly as possible. The best way to do that to ensure your success in the long term is to be debt-free.
Pay your smallest debts first
It is scientifically proven that paying your smallest debts first can alter your human behavior.
To get started, list out your debts from the smallest to the largest. Work on getting rid of the smallest balance first, then celebrate the win!! Then, you can fight harder for the next win and the next.
When you work your way through all your debts, you’re going to have a more successful business. And when you pair that with Profit First, then you’re setting yourself up for lifelong success and wealth.
The best part? When you have paid off all of your debts, instead of paying large quarterly sums to your debtors, you get to keep that money for yourself! When your business is operating within its budgets, with good margins, then you’re set up for a long time.