Let’s talk about paying off debt.
Paying off debt is so important to live financially free that we need to have good strategies in place to pay debt off, especially if the interest rate you are paying is particularly high.
I don’t want to get into the pay off debt vs investing conversation in this article. I’m going to assume since you are reading this you have decided to focus your energy on destroying your debt and you want to know some strategies to go about it.
If you only have one debt… eg. a credit card bill or a mortgage payment then the strategy is very simple. You should just make a big a payment towards that debt as you can until it is all paid!
If you have more than one form of debt.. eg. credit card, car loan, mortgage then how you tackle that debt becomes important.
Let’s talk about two of the main strategies people use to go about clearing debt.
The Avalanche Method
With the avalanche method you will pay off the debt with the highest interest in full, before moving on to the next highest, then the next highest and so on.
You can tell by the name “avalanche” that things will start slowly and as you come to the end of your assault on your debts you will gain momentum until at the very end you will be clearing the tail end of your debts will all the money you would previously have used to pay expensive debt.
- Assuming you are making the minimum payments required on all your debts your focus is on putting as much money as possible to the debt with the highest interest rate.
- Relentlessly put your money into paying that debt off completely, regardless of what the actual amount is and then move on to the next highest debt.
- The goal is to focus on paying the most expensive debt first to save money in the longer term.
- Once you have paid off that expensive debt, then use that same payment on top of the the payment for next most expensive debt and so on…
It might take many months or years before you really appreciate what you are achieving, but after you gain some momentum, your debts will begin to melt away and the amount you will save on interest alone could be quite substantial.
Imagine you have four different debts:
| Debt | Outstanding | Rate |
|---|---|---|
| Car Loan | £9,000 | 4.5% |
| Credit Card | £2,000 | 22.0% |
| Student Loan | £12,000 | 3.2% |
| Mortgage | £100,000 | 2.5% |
So, you should end up paying down the credit card first, then when it is cleared, roll up that payment and everything else you can into the car loan. Then the student loan and then the mortgage.
Advantage of avalanche method
- This is the fastest way to pay off debt
- This is the cheapest way to pay off debt
- Financially this is the best way to pay of debt and if you can tough out the early stages of not seeing much progress you will be richer in the long run.
Disadvantages of the avalanche method
- Take longer to see progress – much of your early payments will be still be paying down interest and it can be hard to stay motivated.
- The finish line can seem very far away at the start
Snowball Method
With the snowball method you tackle the smallest balance first, regardless of the interest rate and when that is cleared move on to the smallest remaining balance and so on.
- Allocate as much money to the smallest balance you have in a bid to clear a debt.
- Once the smallest debt is paid off completely, take the money you were putting toward that, and direct it at the next smallest debt instead.
- Progress in this way through all you debts from smallest to largest until they are all cleared.
Advantage of snowball method
- Paying off your smallest debt first will give you a boost of seeing a relatively quick win
- Motivation is key when paying off debt and seeing a debt disappear can be a great lift for morale.
- You may see an improvement in credit score since you have one less debtor to pay
Disadvantages of the avalanche method
- Not the most cost effective way to pay off debt
- If the debts with the highest interest are also the largest then you could end up paying much more longer term due to interest on your debt.
Two strategies to help you stay motivated in paying down your debt.
Good luck!