“How to pay off debt” is a hard question to answer. There are so many variables to debt, so much unknown about a certain situation, that there is no one size fits all approach to debt payoff. You may have many types of debt, all with different terms. Should you focus on one specific debt in particular?
The first step is to understand the debt you have and all of the variables that the debt has. Prepare a listing of all your debt, including balance due, interest rate, and monthly payment. Once this list is available, you will be able to determine what you need to do to get started.
There are two main debt payoff strategies that many people use in order to focus their debt payments most effectively: The Avalanche Method and the Snowball Method. Let us review what each one means. Then we will run a detailed scenario to look at some numbers to see how things can play out using the two methods.
How to Pay Off Debt: The Avalanche Method
The Avalanche Method is all about paying off your debts with the highest interest rates first. Then, by rolling the payments made into the next highest interest loan when one loan is fully repaid, you create a debt avalanche of ever increasing debt payments. What does this mean? Pretend you have 3 debts:
- Credit Card Debt – $10,000 at 16% Interest
- Student Loan Debt – $8,000 at 8% Interest
- Mortgage Debt – $200,000 at 4% Interset
Using the Avalanche Method of debt payoff, you would put any extra money into paying the credit card first. When you pay off the credit card, you would then take the total payment you were making on the credit card and start paying that on top of the minimum payment of the student loan debt. Finally, you would then use the same method to pay the mortgage debt.
How to Pay Off Debt: The Snowball Method
The Snowball Method is all about paying off the lowest balance debt first, then using that payment to pay off the second lowest balance, continuing until you pay off the highest remaining balance last. This creates a snowball effect in which the payments start off small but grow as you pay off the smallest debt.
Again, assume you have the same three debt instruments as above. You would first pay off the student loan debt. Then you would take the full student loan debt payment and apply it to the credit card debt. Once the credit card is paid, you then move the entire payment over to the mortgage to tackle that debt.
Each method is very simple and straight-forward, but which one is the best for you? Let’s look at a more complicated scenario and see how the numbers fall.
The Scenario
There are seven different debts that you hold that stand between you and your debt freedom goal. You would like to know if the Avalanche Method or Snowball Method would work best for you in order to get your debt paid off and would like them compared to if you just made the minimum payments until the debt was gone. You have an extra $100 per month you can spend on paying off your debt on top of the minimum payments. Your debt portfolio is as follows:
Minimum Payments
What would be the results if you just made the minimum monthly payments on each debt? You would be making debt payments for the next 30 years, as the mortgage is a 360 month loan. On the total loan balance of $244,500, you would end up paying total debt payments of $420,059 over those 30 years with interest of $175,559.
Now lets see what happens if we use the Avalanche Method or the Snowball Method and pay just $100 more a month to the loans.
Avalanche Method
First, lets put the debts in order of highest interest rate to lowest interest rate. This will make it easier to see which debts will be paid off first.
So the order is set. You will begin your journey by putting your $100 towards the Credit Card debt with the interest rate of 19%. You will then continue down the list until your debt has been eradicated!
The auto loan is at the bottom of the list but will be paid off with just minimum payments. After the 30 months of these payment, you will roll the auto loan payment into the highest interest rate debt’s payment.
So what are the results? You will end up paying a total of $334,097 to pay off all of your debt. This includes total interest of $89,463. This method will have your debt paid off in 166 months, compared to 360 months with no additional payments being made.
Snowball Method
Let’s do what we did above, but this time put the investments in order of lowest balance to highest balance.
The new order has been set. You can see a difference from the Avalanche Method above right off the bat. Instead of being last on the list, the auto loan is now your first focus. After paying that off, you will move onto the first of two student loan debts. Then you will start paying off credit card debt, which was the focus on the first debt payoffs in the Avalanche Method. Let’s take a look at how the numbers play out.
It will take total payments of $339,998 to pay off your debt in full. In this balance includes total interest paid of $95,498. It will take you 174 months to fully pay down the debt.
How to Pay Off Debt: The Verdict
The chart above shows the results of the scenario. While, the Avalanche Method clearly has the lowest total amount paid, both methods are far and away better than just making the minimum payments. Not only will you have your debt paid off in half the time no matter which way you choose, you are looking at over $80,000 saved.
Here is the best part. At the end of month 166, you have your debts paid off because you took $100 extra every month and used the Avalanche Method to speed up your debt payments. Deciding that, because you didn’t use the $1,961.44 during your debt payoff to fund your changed lifestyle before, you will take that money and invest it, getting a return of 7%. From month 166 through month 360, when you would have just finished paying off your last remaining debt, you will have accrued $707,071 in your investment account! If getting out from your debt burden isn’t incentive enough, I would say over $700,000 is! Compounding at its finest!
My Thoughts
Throughout my debt journey, I personally have used the Avalanche Method to pay off my debts. I did this before I even knew there were methods to debt payoff. All I knew was the higher the interest rate, the more I was paying to have that debt. That didn’t sit well with me and it shouldn’t with you either.
So if the Avalanche Method results in a lower total payment, why is there even such a thing as the Snowball Method? One word. Mindset.
I didn’t care about achieving small victories in my debt payoff. My largest student loan balance was the one with the highest interest rate. I knew my goal and wasn’t going to let anything get in my way.
That said, having small victories is important to many people. They like to know that they are making progress towards their ultimate goal. This is where the Snowball Method works wonders. By paying off the small balances quicker, you achieve a sense of accomplishment. There is now one less loan payment to be made. That is a huge win! If this is you, go for it! You can see based on the numbers above that there isn’t a huge difference between the two methods.
The important thing is to get your debt payoff journey started. The longer you wait, the less you will be able to use compounding for the greater good of your life! Instead, you will be held captive by its deathly grip. Start making progress today! Your financial life depends on it!