Debt Repayment Methods: Avalanche, Snowball and More
No one likes to take on debt but sometimes taking a loan is necessary in order to reach our goals of going to college, owning a car or a home or running a business. Borrowing isn’t necessarily a bad thing (remember, there is good debt and bad debt) as long as you have a solid plan to pay back as quickly as possible. What’s the rush? Compound interest. It increases the amount you owe every day you still have the debt, because borrowing money is not free!
If you have some extra money in your budget and your goal is to pay your debt off faster, the best place to start is making a list. The list should be every debt that you owe, the interest rates, minimum payments, and outstanding balance for each. If you have several credit cards with high interest rates on that list, you might consider applying for a balance transfer card that offers a low, or zero, interest rate for a period of time (usually about a year). This temporarily lowers or stops the interest adding to your current balance and gives you time to make every dollar you put toward the debt count. There are also personal loans available from many lenders as another way to consolidate high interest debt into a single loan with a lower interest rate. Another method of consolidating debt such as credits cards (unsecured) is a home equity loan (secured). But be careful because even though you may get a lower interest rate, your home will be at risk if you can’t make your payments since you’re swapping out unsecured debt for new debt secured by your home. All of these methods require you to apply for new credit, so the approval and rate you get will depend on your credit history.
Whether you have re-financed to reduce your interest rates where possible, or are just working on existing debts, select a repayment strategy that works best for you. A common question is if you should start by paying off the debt with the highest interest rate or the one with the smallest balance. There is no wrong answer, however you pay off debt is a good thing, but paying off the highest interest debt first (called the debt avalanche method) will mean you pay the least interest on your debt in the long run. It’s mathematically the “cheapest” way to pay off debt. An alternate method, the debt snowball, starts with the smallest balance and works up to the largest balance.
The debt avalanche prioritizes paying off debt with the highest interest rate, saving you money in total interest paid compared to other methods. You begin by making minimum payments on all debts every month (very important). Then you focus all additional money, including any windfalls (tax refunds, bonus, selling stuff, side gig, etc), on the debt with the highest interest rate until all are paid off.
The debt snowball prioritizes paying off your debt with the smallest balance, moving to the next smallest once the first one is paid off, gaining momentum as each debt is paid off. It may give you a sense of accomplishment to see individual debts drop off quicker, but it probably will cost you more (depends on size of debts / interest rates) in interest compared to the debt avalanche. You begin by making the minimum payments on all your debts every month, same as the avalanche method. Then you focus all additional money, including any windfalls, on your smallest debt until all are paid off.
As you pay off debt, try to leave the the line of credit and credit cards open where possible, but stop using them. Closing them can lower your credit score. Instead, just cut up any credit cards or put them away so you aren’t tempted to use them. Paying off your loans and other debt is good for your financial well-being and for your credit score. It will give you a boost of confidence about your future and reinforces good financial behavior.