With more people becoming buried underneath monthly payments every day, learning how to get out from underneath them is all the more relevant. There are two strategies you can use to accelerate your payoff time. Depending whether you are more motivated by math or emotion depends on the best way to pay down your debt quickly.
These methods work with most consumer debts such as credit cards, auto loans, student loans, and personal loans. They will not work with mortgages or other relatively large and inexpensive debts. Essentially, you list out all your debts and pay the minimum on each, except for one. Deciding which debt to tackle first is based on which strategy you use.
Debt Avalanche
The Debt Avalanche strategy involves taking the debt with the highest interest rate and paying it down first. Mathematically, this approach leads to the most savings, and if your debt mountain is large enough it could shave off a significant amount of time until you are free and clear.
This is the equivalent of finding the most important work to get done and doing it first, even if it is the least appealing or most work. I prefer this method of paying down debt even if I prefer the Snowball Method when it comes to household work!
This method is best when you are in a very secure place financially. You are looking at a longer horizon before you get to see any emotional progress, so you need to know that you are not likely to lose your job or have major bills coming up to derail you.
In Practice
Let’s say you have three loans outstanding and you can spare an extra $1,000 a month to pay down debts.
$5,000 Student loan at 5% interest
$7,500 credit card debt at 20.99% interest
$15,000 car loan at 3% interest
With the avalanche method, you would focus on the credit card debt first as it has the highest interest rate, then student loans, then the car loan. You will end up paying approximately $345 less than if you used the Snowball Method.
In the Real World
If you can keep your emotions out of the decision making process and focus on making the payments, this method is the ideal approach to paying down debt. The potential problems arise when emotion gets involved. You may not feel any progress until many months from when you begin, especially if your highest interest debt is a rather large one. It requires you to constantly devote a significant amount of money towards your debts. If your living situation changes or an emergency pops up, you might get derailed.
Debt Snowball
The Debt Snowball strategy is where you pay the smallest balance debt first. Mathematically this is not ideal, but it does result in major motivation bumps every time you pay off a balance. As personal finance is largely an emotional topic, sometimes it is better to do what makes us feel better, even if the math says there is a better way.
The Snowball Method is the equivalent of doing the easy and quick tasks before doing the long and monotonous work. I prefer to get the easy things out of the way in my day to day life; it is much nicer to say you completed three things in one day than to say you are halfway through one.
This method is best when you need to hit milestones to stay motivated. It is also best when you know you might have major life changes coming up such as changing jobs or big expenditures. By having individual loans paid off you will have eliminated their minimum payments, giving you more cashflow if you need to shift back to paying the minimum.
In Practice
Let’s use the same example as before.
$5,000 Student loan at 5% interest
$7,500 credit card debt at 20.99% interest
$15,000 car loan at 3% interest
With the Snowball Method, you will pay the student loan, then the credit card, then the car loan. You will pay off the first balance much faster than you would under the Avalanche Method, resulting in a good shot of motivation to continue and to see progress. You will pay more in interest, but if the motivation keeps you on track where the Avalanche Method won’t, then you should consider it a win.
In the Real World
The fact that you can see the progress as your balances are zeroed out is incredibly motivational. Also, if an emergency were to pop up, by having a handful of monthly payments gone you can easily swing your budget to accommodate the changes you need to make.
The downsides of course are that you will be in debt longer and will pay more interest. That is the price you pay for emotions but if it gets your debt paid off when nothing else will, then at the end of the day who cares?
Final Thoughts
If you know you will be losing your job soon or something else drastic, it would be best to only pay the minimum and set aside the extra as emergency savings to help get you through it.
Extra consideration should be given to special financing. If you have a debt that is, let’s say 0% interest for 24 months, then you need to make sure you will have it paid off in less than 24 months. Most times these loans will retroactively stack interest on top for the entire period it remained unpaid, so you could be looking at a full 2 years of interest all because you paid it one day too late!
While both methods will get you to the same end result, the process in the middle needs to match your situation and personality. Only you know which is better for your situation.
