When the debts start piling up and the monthly payments become difficult to look at it can be hard to believe there is a way to dig your way out of debt. But there is!
Before you begin paying down your debts it is important to realize how you got to this position in the first place. If you are carrying significant credit card, retail, or vehicle debts you’ll want to make sure you don’t continue to add to those debts. Largely, this means cutting up credit cards, avoiding vehicle leases and buying new cars only to sell them for less than the remaining loan amount a few years later. Once you have identified the source of your debts and stopped adding to the pile of debts you are now ready to tackle them head-on.
There are two ways to take go about eliminating your debt, the debt avalanche and the debt snowball.
The Debt Avalanche: In this method you will write down your debts in the order of the highest interest rate to the lowest interest rate along with the minimum payment required for each debt. Once you have made the minimum payment on each account you’ll use your remaining funds to attack the debt with the highest interest rate. This method is the logically the optimal way to quickly pay down your debts. Overall you will pay less money compared to the snowball method by getting rid of the debts with the highest interest rate first.
- The Debt Snowball: In this method, which was popularized by Dave Ramsey, you write down your debts in the order of balance size with the lowest balance account at the top of the list. By making all of the minimum payments and then using the remaining funds to pay down the smallest debts you’ll get a few quick wins in the satisfaction of having paid off part of your debt in full. Each time you eliminate a debt you also free up the minimum payment which you can then put towards the next debt. The downside of this method is that you continue paying the high rate of interest on the higher interest debts.
Here’s an example of how this would look in real life.
- Credit Card: $11,000 balance with a minimum payment of $100/month, 20% interest
- Vehicle Loan: $5,000 with a minimum payment of $300/month, 4% interest
- Amount available to pay down debts: $600
We needs to first pay $100 + $300 = $400 to make the minimum payments on both debts loans so the payments are recorded as “on time.” The additional $200 can go towards either the credit card balance (highest interest rate, avalanche method) or the vehicle loan (smallest balance, snowball method).
So, which method is best?
This is where you’re going to need to really know yourself. The avalanche method is definitively the optimal method for paying down debts, but the psychological benefits of paying off small debts can inspire you to dedicate more time and energy to paying down the debt. Keep in mind that none of this is set in stone. You can change your method at any point – the most important part is that you are aware of your situation and you are actively working to alleviate yourself of the debt burden. Always keep in mind how great it will feel to finally say that you are debt free and how you will be able to put those monthly payments toward a much better use!