Paying off debt can be very hard for everyone, but it doesn’t have to be. It can be overwhelming, but it doesn’t always have to be this way. As long as you start attacking that debt with the right method, you will become successful.
There is a terrific method to knock out debt quickly and it is called the debt snowball. There is another method called the Debt Avalanche that works almost as well. As long as you know what method works best for you, your debt can be paid off much faster than you might think. With the right steps, you could achieve the financial freedom you’re waiting for.
Debt Snowball vs Debt Avalanche
There are two known methods to make debt payments namely: the debt snowball and the debt avalanche. They are useful strategies to pay off debt. Each are good methods but I believe one is a better and easier method while the other could make greater impact on the repayments.
While they both require a person to list out debts and make minimum payments for each, the way you pay off debt is different for each.
The debt snowball basically pays off the debt with the lease amount of money. Then you take the payment from the smallest, once it is paid off, then pay all of that to the next smallest debt. You work your way up through all your debts.
The debt avalanche is where you pay the debt with the highest interest percentage first and the work your way down from there. This way, you are saving yourself money by not paying as much in total interest because you are paying off the highest percentage debt first.
Although they have different approaches, they will result getting debt out of one’s life effectively.
The key to paying off debt is to just start. Start paying extra to any of the debts you have to get that debt removed. Paying the minimum will hurt you rather than help you.
The Debt Avalanche Method
The debt avalanche method is also known as debt stacking. The method is done by paying off more towards the debt with the highest interest rate first and moving downward. Through this, one gets rid of the biggest obstacles first making it easier to finish up the rest of the repayments.
In this method, the debts are arranged according to their interest rate, regardless of how high or low the balance. Simply, one starts to pay off the highest interest rate going lower.
For example a person’s debt is listed as follows:
$3,000 on personal loan with an interest of 3%
$4,000 on car loan with an interest of 2%
$2,000 on credit card debt with an interest of 6%
If one were to have $500 a month to pay toward debt, and a total of $350 of minimum debt payments, the remaining $150 goes towards the credit card debt because it has the highest interest.
The Debt Snowball Method
While the avalanche method starts from the highest interest rate, the snowball method starts with the lowest balance.
It is said that this approach works best for borrowers because it was made to keep them motivated.
The snowball method starts paying off the smallest amount of debt first, in a list arranged from the lowest debt balance to the highest regardless of the interest rate. One simply moves on to the next smallest debt after it’s been fully repaid.
By slowly decreasing the number of debts to pay, it gives a person the thought that they are quickly lessening their financial burden therefore inspiring them to continue. Once a debt is paid off, you take that entire payment and then apply it to the next smallest debt.
With a list of debt arranged accordingly, an example may be:
$5,000 on personal loan with an interest of 6%
$2,000 on credit card debt with an interest of 8%
$3,000 on auto loan with an interest of 3%
Using the snowball method, if one were to have $700 for debt payments monthly and the total minimum debt is $400 in a month, the extra $300 goes toward the credit card debt because it has the least balance despite having the highest interest rate.
When the $2,000 credit card debt is finished, they can move on to using the remaining money each month for paying off the auto loan since it would now be the lowest balance on the list.
The key is to take ALL the payments from each debt you pay off and apply it to the next debt.
Is the Debt Snowball the Best Method for Paying Off Debt?
Others prefer the debt snowball method over the debt avalanche because of the fulfilling feeling it gives when a debt is crossed off the list, no matter how small. Some people would say it is the best method there is for paying off debt because it keeps them motivated.
Although, mathematically, the debt avalanche method can definitely save you more money –which is another aspect that should be given consideration. This is because you don’t have to worry about having to pay for high interests in the long-run.
The debt snowball method is said to allow a person to save money when the debts are paid off. By starting from the smallest balance, the process of finishing payments happens faster.
While a person still has to constantly put extra money towards paying their debts, it allows them to see the end of their debt faster. The progress happens right in front of them therefore keeping them motivated to continue especially knowing that they could save lots from doing so as time passes by.
It might not seem like a big deal to be inspired to pay off debt. However, if one were unmotivated and always found paying debts something bothersome, the end would feel further than it actually is. A mindset like this could cause someone to stop making the payments or pay less than how much they usually would.
From this, one can tell that it relies more on the mindset and behavior of a person rather than the mathematical essence of paying debts.
As Dave Ramsey says, “the problem with your money is not your math. It’s the person in the mirror.”
How the Debt Snowball Method Works
The debt snowball method is simpler than it may seem.
To summarize, a person just has to knock off the smaller payments one by one until they reach the last debt.
After finishing one debt repayment, they simply have to move on to the next lowest balance and it continues on until every debt has been completely repaid.
In a step-by-step process, it would look like this:
- Arrange the debt payments in order of lowest to highest in balance, regardless of how high or low the interest rate is. The balance should be the only focus.
- Make minimum payments for each debt on the list every month, expect the one with the lowest balance.
- Pay off the debt with the smallest balance with as much as money as possible, preferably the minimum payment with the additional extra cost from the budget.
- Move on to the next lowest debt balance after finishing off the last one.
- Take the entire payment you were paying on the first debt you paid off and pay it to the next debt.
- Repeat the process until every debt has been paid in full.
Should I Pay Off the Smallest Debt First?
Based on the debt snowball method, it is much more effective to clear debt when the lowest balance is the starting point.
If the smallest balance were to be paid off first, the payer is able to see each of the debts being quickly knocked off their list. Because of this, they see the progress clearly rather if they were to wait until they see a big change in their repayments.
Plus, that minimum payment you were paying to that debt is removed and you are now paying that money towards the next debt.
However, this only bases off the balance itself regardless of the interest.
The interest rate can add up a lot to the total of a payment, especially when the given rate for the loan is quite high. The debt snowball method disregards this and looks only at the balance alone.
By basing payment priorities off only the balance, it perceives the act of paying debt as something simpler even though the payment they are making may be higher than the others due to the interest rate.
When a person believes a dent is being made on their debt whenever they make a bigger payment on the lowest balance, it affects how efficiently they make their payments.
Clearing the smaller payments allows someone to have more money to pay down the next smallest debt.
For example, if a person’s list of debt contains the following:
$3,000 on auto loan with a minimum payment of $230
$2,000 on credit card debt with a minimum payment of $150
$1,000 on personal loans with a minimum payment of $120
They would start paying off their personal loan first with a balance of $1,000.
If they had a budget of $650 for their monthly debt payments, the computation would be: $230 towards auto loan, $150 towards credit card debt, and $270 towards personal loan.
Once the personal loan is paid off, the next amount for every month would be: $230 towards auto loan and $420 towards credit card debt.
Therefore allowing the payer to make bigger payments that would make the process quicker.
How the Debt Snowball Affects Your Credit
When credit card debt has been paid off, the credit score is most likely to change as well.
The debt snowball method allows a borrower to pay off their debt consistently. Simply paying on time is crucial when credit score is being evaluated, since this shows how regularly the borrower makes their payments.
The method would also make minimum payments for each debt every month, which also affects their efficiency in paying because of the amount they pay on the focus debt.
If it happens to be the credit card debt, they will be able to pay for bigger chunks of the debt therefore making positive changes to one’s credit score.
Despite having great effects, it also has its downsides.
Credit utilization is the percentage of credit card limit a person is currently using –which makes a big influence on credit score. After paying off debt, the credit score could drop.
The key would be to keep the credit card open and not close the card. That makes your total debt to credit low and make you an attractive borrower.
There’s no problem with having a credit utilization of 30% or lower. What would harm the credit score is having no credit utilization at all.
How the Debt Snowball Works – Practical Example
To see how the debt snowball method works in more detail, here is an example.
Say a person has five different debts namely with a $800 monthly for paying off debt:
- $3,000 on credit card debt with a $100 payment
- $5,000 on auto loan with a $240 payment
- $8,000 on student loan with a $150 payment
- $400 on medical bills with a $60 payment
- $1,000 on personal loans with a $80 payment
As mentioned, the debt snowball starts at the lowest balance on the list which is the medical bill in this case. $230 of the budget goes towards paying this, with $60 of the minimum payment and an extra $170.
In two months, the medical bill will have been fully paid off already. Therefore allowing the person to move up their list to the next lowest balance available.
Their personal loan of $1,000 is now the debt with the lowest balance, therefore this will be the new focus debt. With $60 taken out from the initial minimum payments, there will be an extra $230 to add onto the minimum payment of $80 for personal loan.
This debt will be fully paid off in around three months with a consistent payment of $310.
With more debt being checked off the list, a bigger amount is allotted for bigger payments. It continues until the last of the debts have been completely repaid, then followed by a debt-free life.