Debt is something that a lot of people live with and not all of them are interested in paying it off. Debt comes in many forms, such as from credit cards, student loans, mortgage loans, personal loans and auto loans. It is good to have some forms of debt otherwise you would have no credit history, but you should use debt responsibly. If you’ve decided it’s time to take steps to pay off credit cards or student loans, then give yourself a pat on the back. The next step is deciding how to best pay off your debt, so we’re going to look at two common methods to pay off debt when you have several separate balances: the snowball method and the avalanche method.
What is the snowball debt method?
The snowball debt method is the process of paying off each debt from smallest to largest. Once you pay off the smallest balance, then you move on to the next smallest one and begin to pay it off. This process continues until you have paid off all of your debt. This may work well for people who struggle to pay off debt and need to take small steps and use each accomplishment to build confidence to pay off the next debt. This is so that once you get to the larger amounts you have already paid off some debt and closed the accounts so you’re ready to take on the big ones.
So let’s say you have 4 debts: 1) $5,690, 2) $10,428, 3) $672, and 4) $2,316. With this method you would pay off the $672 first, next the $2,316, then $5,690 and finally you would tackle the $10,428.
What is the avalanche debt method?
The goal of the avalanche debt method is to minimize the amount of interest you pay on your debt and accumulate while paying it off. The avalanche debt method works by paying off each debt from highest interest rate to lowest interest rate. This method saves you on interest compared to the snowball method because while you’re paying off the smallest debt, you are still accruing interest on the larger ones. By paying off each debt according to the interest rate, you are minimizing the amount of debt you’ll have to pay to lenders.
Going back to our example, let's say these are the interest rates for the 4 debts:
1) $672, 8.80%
2) $2,316, 7.30%
3) $5,690, 9.15%
4) $10,428, 6.40%
With the avalanche debt method you would pay them off in order of the highest interest rate to the lowest, so this would be the order: 1) $5,690, 9.15%, 2) $672, 8.80%, 3) 2,316, 7.30% and 4) $10,428, 6.40%.
Which method is better?
We recommend using the avalanche debt method instead of the snowball debt method. While someone is using the snowball debt method they could be racking up significant amounts of interest because they aren't paying off the debts with the highest interest rate first. This means that not only will it take longer to pay off the debt, but you will also be wasting money on interest. If your interest rates are very close together then it might not make a significant difference, but usually interest rates on different forms of debt vary and that is why the avalanche debt method was created.
How much debt can you afford to pay off?
If you don’t already have a budget or you don’t use it, you should make a monthly budget and make the decision to stick to it. Learn how to create a monthly budget and several ways to help you stick to your budget. Remember that you still need to pay each minimum balance due - setting up automatic payments should be helpful. Once you have logged all of your expenses for the past calendar month, remember to evaluate what you’re spending money on and cut any unnecessary costs. You’re trying to achieve financial freedom and that means sacrificing a bit until you get there.
Creating a monthly budget should allow you to see how much you can put toward paying off debt and how much you should be saving. Don’t forget that you need to put some money in a savings account each month in case of an emergency - this way you won’t have to rack up more debt in case an unexpected event happens.
Once you decide how much each month you can put toward paying off your debt, do it! Decide what day each month you’ll make the extra payment, set a calendar reminder and stick to it. Put any extra money that you did not budget for, like tax returns or year end bonuses, toward paying off your debt. It will take commitment and dedication, but you can pay off your debt and achieve financial freedom.
To help you in your efforts to pay off debt, learn about some ways you’re losing money without realizing it.
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