When it comes to debt payments, you may come across many pieces of advice with some insisting that you should consider the interest rates
while others you should look at the amounts. While you can use both methods and finally settle your loans, sorting advice might be tough as it might land you to financial troubles.
There are many methods that you can use to settle your debts, but the primary ones are the snowball method and the debt avalanche method. Our guide will give a summary of each method to help you choose the one which suits you well. Check them out.
1. Debt Snowball Method
This is a debt reduction method, where the borrower decides to pay off multiple debts by starting with the ones with the smallest balances
. When the smallest payments are cleared off, one then proceeds to the other. The debts with the most copious amounts are paid last when using this method. Debt snowball method is often used when repaying revolving credits such as the credit cards.
Debt Snowball Basic Steps
- List all the debts starting with the ones with the smallest dues to the ones with the largest balances.This is the main distinctive feature of this method. The order can only be determined by the balances only, and not the standing interest rates. If you have two which have very close figures, then the one with the relatively higher interest rate will be moved above.
- Start paying off the debts in the organized order. You can pay the minimum payable amount of the smallest debts then contribute a small amount the next one, until the settle them. However, note that some lenders especially the car companies or mortgage lenders will increase their rates when the borrower’s delays hence they must be contacted early enough so that they can only increase interest on the principal amount only
- Once you are done with the smallest debt payment, move on to the next one and repeat the chain until you settle all the debts.
Debt Snowball Example
||Regular + Extra Payment
Assume that you have the following debts, and you want to pay them using the snowball method (you don’t consider the interest rates in this method)
- $500 medical bill (minimum payable amount of $50)
- $2,500 credit card debt with a minimum payable amount of $63
- $7,000 car loan with minimum pay of $135
- $10,000 student loan with a minimum payable amount of $96
The medical bill has the smallest debts amount, and thus you will start your debt repayment journey by settling it first. If you plan to use $500 of your salary to pay your loan every month, then you will solve the medical bills debt for the first month. If you start to pay the credit card debt on the following month, you will settle the debt within four months. The car loan will take around ten months, and finally, the student loan will take around one year.
Debt Snowball Pros and Cons
|Motivation – it feels good to see the progress of your debt repayments since you will only move to the next one you are done with the least. Seeing your hard work pay encourages you to stay on the track.
||It will cost you more – As compared to the avalanche method, making the minimum payments even on the debts which have a higher interest will make you pay more in the long run.
2. The Debt Avalanche Method
This is a type of debt payoff plan, where the debtor assigns a sufficient amount of money so the minimum payment on each debt could be made. When the payment is made the debtor allocates remaining debt-repayment funds to the debt with the highest interest rate. And when the debt with the highest interest rate is finally paid off, the extra repayment funds go toward the next highest interest-bearing loan. The method is ongoing until all the debts are paid off.
Debt Avalanche Basic Steps
- List down all your debts, by starting with the ones with the highest interest rates. You will not be worried about the loan servicer or provider when using this method, but rather on the interest rates only. In most cases, the credit cards will top the lists due to their high interest rates.
- Once you have made a list, it’s upon you now to come up with a good plan of how much you will start contributing; this will depend on your level of income as well the minimal payable amounts of the debts.
- Pay the minimum of each debt, and then put the extra amount on the obligations with the highest interests. You can get extra money by looking for other income generating means to help you settle your debt quickly.
- Repeat the cycle every month. Eventually, you will settle all the debts if you plan well, follow your budget and maintain a good debt payment discipline.
Debt Avalanche Example
All My Debts (Debt Avalanche Method)
- Credit card loan with a balance of $7,500, minimum payment of $150 and interest rate of 18.99%
- Credit card two with a balance of $500, a minimum payment of $25 and interest rate of 9.99%
- A student loan of $15,000, the minimum payable amount of $150 and a 10% interest rate
- A car loan of $8,000, a minimum payment of $250 and an interest rate of 12%.
|Credit card loan
|Credit card two
Assuming that you have a monthly budget of $600 towards the debts, you will start with the debt with the highest interact rate, and that is credit card one, followed by the car loan, student loan the credit card two.
Debt Avalanche Pros and Cons
- Pays off your debts faster – unlike the snowball ball method, you will settle your debts quicker when you use this method. This is because you throw big chunks of money toward the debts.
- More savings on the interest – since you will be dealing with the debts which have a more significant interest first; you will settle them first before the interests accumulate.
- No motivation â€“ if the debt with the highest interest is the one with the highest debt amount, then you might take a more extended period before you pay it first.
- Takes commitment and discipline to put off. It is quite easy to revert the minimum payments of the debts when you get unexpected expenditure.
Which Method Should You Use?
Well, personal finance is based on individual decisions. The key is, to be honest on your budget and use the method that won’t hurt you. However, itâ€™s okay to experiment both methods and see which one will; favor you. If the debt avalanche method seems quite appealing to you, then try it for several months. If you find out it’s not working well on you, switch to the snowball method and experiment it.
With that said, consider these factors when choosing between the two:
- Your interest rate situation – If one of your debts has an incredibly higher rate than the others, then itâ€™s good to settle it first especially if it’s not possible to refinance it. This will free up your money to pay off the others.
- Your financial decision-making drive – If you are the type of people who are driven by emotions, then it would be wise to use the snowball method. As discussed above, the method is motivational since you can see the efforts of your hard work quickly.
It’s good to have a personal financial plan
, although you should not necessarily hold on to it for 365 days or more. Things change, and hence you should learn to adapt. Change your financial strategies
until you get the best plan. If you are still not comfortable with both methods, talk to a financial advisor for help.