Debt Payoff Methods

Debt Payoff Methods

There are two common approaches to paying off debt. These approaches are typically referred to as debt snowball vs debt avalanche. Below I will discuss in detail what each of these means.

Before delving into the differences in how these methods work, it is important to understand that you should always make at least the minimum payment on all of your debt. What I mean by this is you should never skip a payment on one type of debt in order to help pay off another debt more quickly. When focusing on which debt to eliminate first, you pay the minimum payment for all of your debts and then put any extra money towards the one debt you are trying to payoff first.

Debt Avalanche

The debt avalanche strategy entails paying off your debt with the highest interest rate first and working your way down to the one with the lowest interest rate. The higher the interest rate, the more money you are paying over the actual amount borrowed. For example, if I borrow $100 with a 10% interest rate per month, I will have to pay back $110 after just the first month. With compounding interest (see the Financial Dictionary for the definition of compound interest) the amount you owe can increase quite rapidly. By paying off the debt with the highest interest first, you try to ensure that you pay the least amount of interest keeping your amount owed as close as possible to the amount actually borrowed. Let’s look at the debt avalanche method as a real life example.

Joe has 3 different types of debt outstanding: 1) $750 in credit card debt with an APR of 24.99% 2) $5,000 in student loan debt with a 6% interest rate and 3) another $6,000 in credit card debt with an APR of 29.99%. Joe has committed to putting an additional $150 a month to paying off his debts.

If Joe wants to utilize the debt avalanche method, he should pay off his debt in the following order: first, pay off the $6,000 credit card with the 29.99% APR; next, pay off the $750 credit card with the 24.99% APR; lastly, pay off the $5,000 student loan debt with the 6% interest rate.

As you can see, the debt avalanche method does not take into account how much debt is outstanding of each kind, but solely focuses on the interest rate.

Debt snowball

The debt snowball approach requires paying off the debt with the lowest balance first. The supporters of this method believe that paying off the debt with the lowest balance first is best because you see results sooner, rather than later. For example, if I have 3 credit cards with balances of $400, $750, and $900 I would pay off the $400 credit card first as it allows me to eliminate one of my debts quickly. The theory here is that paying off one debt will help motivate you by giving you a sense of accomplishment. This approach is viewed as the more emotional one. Let’s look at our example of Joe, again, but this time applying the debt snowball approach.

Joe has 3 different types of debt outstanding: 1) $750 in credit card debt with an APR of 24.99% 2) $5,000 in student loan debt with a 6% interest rate and 3) another $6,000 in credit card debt with an APR of 29.99%. Joe has committed to putting an additional $150 a month to paying off his debts.

In this case, Joe would pay off his debt in the following order: first, pay off the $750 credit card with the 24.99% APR; next, payoff the $5,000 student loan debt with the 6% interest rate; lastly, pay off the $6,000 credit card with the 29.99% APR.

As you can see, this method does not factor in interest rates at all. The focus here is to make sure you pay off the smallest balance first and work your way through leaving the largest balance for last.

 

I personally believe that the best approach can often be a combination of these two methods. My advice to Joe would be to pay off the $750 credit card first, as this is the most attainable and can be done much easier than the other two. Next, he should focus on paying off the $6,000 credit card debt because the interest rate on this debt is significantly higher than the student loan debt. The student loan debt should be last as it has a much lower interest rate, making the amount owed more manageable in the longer term than a higher interest debt.

Now that you know the two most common strategies for paying off debt, what method do you think works best? Are there other methods that you, or someone you know, have used to pay off debt?

2 thoughts on “Debt Payoff Methods

  1. I agree with you on combining the two methods of debt pay off. I think you get more bang for your buck that way.

    Debt snowball works for many people, as the psychological boost of paying off the lowest debt helps motivate them to keep going, but paying off the higher interest rate debt will save, so it’s wise to look at both.

    Cool that you brought that out.

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