From credit card debt to student loan payments to mortgage debt, many people have something that is weighing them down financially.
Whatever your specific situation is, debt takes a toll on your personal finances and you, and it can feel impossible to hope for a debt free future.
Without a good strategy to help you break down your total debt into manageable chunks, it is definitely hard. Using one individual’s story we’ll show you how to approach your debt with a plan (2 different ones to be precise).
What to Know Before You Pick a Strategy
Before you decide on a plan of action to eliminate your debt, you should learn how to prioritize and why. When deciding what debt to pay off first, think about:
1. The Size of Debt
List all your debts, including credit card balances, loans, and any other financial obligations. List everything off from the smallest debt amounts to the largest.
2. Impact on Credit Score
Some debts may have more impact on your credit score than others, like overdue credit card payments or outstanding debt from loans. Having credit card debt will make your credit utilization rate higher, which can lower your credit score.
Prioritizing high interest debt, like credit card debt and loans, will help you save money in the long run and help your debt payoff plan take off. Always make at least the minimum monthly payment on time to avoid hurting your credit score.
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Debt Avalanche Method vs. Debt Snowball Method
Tony has debt from credit cards, personal loan debt, and car loan debt:
- Credit Card A: $5,000 balance at 22% APR
- Personal Loan: $8,000 balance at 10% APR
- Student Loan: $15,000 balance at 6% APR
- Car Loan: $20,000 balance at 4% APR
The two main strategies he can use to pay those debts down are the debt snowball method and the debt avalanche method.
What’s the snowball method, and how does it work?
The debt snowball method has you focus on paying off the smallest debt first, ignoring any difference in interest rates. This way you can get quick wins and build confidence.
How to Use the Snowball Method:
- List Your Debts: List everything, like credit card balances, personal loans, or any other outstanding bills.
- Arrange by Balance: Start with the smallest balance and go down to the highest balance.
- Set Aside Extra Payments: Set any extra funds aside so you can start paying off your smallest debt while making minimum payments on all your other debts.
- Celebrate Small Wins: As you pay off each debt, celebrate! When you break debts down into smaller challenges, it can feel easier to conquer them.
- Snowball Effect: Once you pay off your smallest debt, take the money you were using to start paying off the next smallest debt on your list.
Repeat and Accelerate: As you keep going, you’re able to increase the amount you put towards each debt. This momentum is the “snowball effect” that helps your debt repayment speed up.
What does this mean for Tony? If Tony used the debt snowball method, he would start by paying the credit card balance on Credit Card A first, then pay off his personal loan, move on to the credit card balance on Credit Card B, and finally, attack the car loan.
After paying off Credit Card A, Tony puts more money (plus the minimum payment) towards paying off the personal loan, which is his next smallest debt, and so on.
If Tony used the debt snowball method, he would only focus on the amount of the debt, paying it off from smallest to largest. The interest rate or any interest payments do not matter for this strategy.
What is the Debt Avalanche Method and How Does it Work?
The debt approach method can save you time and money by lowering your overall interest payments. It can feel daunting though, because you’re focusing on larger balances that take more time to pay off.
How to Use the Avalanche Method:
- List Your Debts: Begin by listing all your debts, including credit cards, loans, and other outstanding balances.
- Arrange by Interest Rate: Organize your debts from the highest interest rate to the lowest interest rate.
- Allocate Extra Payments: Set any extra funds aside so you can start paying off your debt with the highest interest rate, while still making minimum payments on all your other debts.
Focus on High-Interest Debts: Focus on paying off the highest interest debt first, that way you keep the amount of interest from building up over time.
If Tony used the avalanche method, he would prioritize paying off debts in the following order, starting with the highest interest debt:
- Credit Card A: This debt has the highest interest rate (22% APR). Tony sets aside extra money to pay off this debt, while still making minimum monthly payments on the other debts.
- Personal Loan: Once Credit Card A is paid off, Tony moves on to the personal loan, which has the next highest interest rate (10% APR).
- Other Loans: After paying off the personal loan, Tony focuses on the student loan, followed by the car loan.
Which Is Better, the Debt Snowball Method or the Debt Avalanche Method?
So, which strategy should Tony pick, the debt avalanche or the debt snowball?
Both strategies are great for tackling debt, but it depends on his personal finance goals and how he handles money.
If Tony wants to save money and focus on high interest debt, the debt avalanche method is great for him. On the other hand, if he needs quick wins to keep him on track, the debt snowball method could be the way to go.
To recap, here’s a breakdown of each:
Debt Snowball Strategy
- Pay the lowest debt amount first, then move on
- Helps you get quick wins
- Can feel easier to get started
Debt Avalanche Strategy
- Focus on higher interest debt first, regardless of amount
- Can save you money in the long run on interest
- Can feel harder since the focus is on chipping away, not eliminating all of one type of debt before moving on
Handle debt, build your credit, and stay on top of your finances
What about you?
Keeping your debt under control and eventually being debt free is about more than just making your minimum monthly payments. It’s also about building good habits that you can feel comfortable with.
Keep these overall strategies in mind:
- Set a Budget: Create a monthly budget to track your income and expenses. The 50, 30, 20 Budget Rule is one place to start. With this rule, you set aside 50% for Needs, 30% for Wants, and 20% for Savings and Paying Off Debt.
- Start an Emergency Fund: Pad your savings account as much as you can to cover unexpected expenses so you don’t need to rely on credit for emergencies.
- Monitor Your Credit: Check your credit report often and monitor your credit score to see where you can improve.
Whatever your long term goals are, Kikoff provides fair, effective, and simple tools that empower you to meet your financial goals.