So, where do you start when you know the bills have been piling up and you feel anxious about your finances? The best way to start is to make a plan for how you plan to pay down your debt and get started from there. When you're paying down debt, knowing that you have a plan in place to pay off your debt will help you stay on track.
The first step for all of these methods is the same, and that's to get a good idea of what your debt looks like. Write down everything you owe, including the balances and the interest rate you're being charged for those balances. Next, look at your budget, figure out your monthly expenses, and how much you can allocate towards debt repayment and savings. While getting out of debt is most certainly a priority, adding to your savings is always important when possible. Savings will help you avoid taking on more debt if you have an unexpected expense.
Next, we'll look at the three main methods used for paying down debt, the Avalanche Method, the Snowball Method, and Debt Consolidation.
The Avalanche Method
When using the Avalanche Method, you'll make minimum payments toward all your bills except for your bill with the highest interest rate. After you've paid all the minimum amounts toward your bills except the one with the highest interest rate, you'll put everything else you have set aside for debt repayment toward this bill. Once you pay one bill off, you move onto the next one, and so on.
For example:
You have $600 budgeted to pay toward your debt.
Here are the bills you have:
Credit Card: $2,000 at 18% APR, $50 minimum payment
a
Low-Interest Credit Card: $10,000 at 6% APR, $150 minimum payment
Personal Loan: $6,000 at 5.5% APR, $100 minimum payment
In this case, you would make your minimum payments which would total $300. Then you'd put the extra $300 you have budgeted for debt repayment towards your credit card payment because it has the highest interest rate. Once you pay off your credit card, you'd take the extra money you have in your debt repayment budget and put it towards your low-interest credit card next, and then move on to your personal loan last.
As you can see, once you pay off the first credit card, you would have even more to put toward your next bill. While you may have been paying an additional $300 toward your first credit card, once it's paid off, you won't need to worry about its minimum payment anymore either, so now you'll have an extra $350 to pay toward your low-interest card. Once you pay that card off and move onto your personal loan, you'll have an additional $500 to pay towards that loan. Once one bill gets paid, they all start to tumble faster and faster, hence the name Avalanche.
The advantage to the Avalanche Method is that you will pay less in the long run. Prioritizing the bills with the highest interest, regardless of their balance, will also cut down on how long it will take to pay off your debt. This is all because it doesn't allow interest to build up or compound.
[Compound interest is essentially interest on top of interest. When your interest is added to the balance of your loan and you’re charged interest on that new balance, that is interest compounding. Not all loans do this, but most credit cards that carry balances do. Be sure to look at the conditions of your loan to see if your interest is compounding.]
The disadvantage to the Avalanche Method is that it can be discouraging when it takes a while to see results at first. It frequently takes you the longest to pay off the first bill or two with the Avalanche Method because more of your payment goes toward interest as that interest is the highest.
The Snowball Method
The Snowball Method is very similar to the Avalanche Method, except instead of prioritizing the bills that charge you the highest interest, you'll prioritize your smallest bills first. Let's look at the same example we did for the Avalanche Method, but apply the Snowball Method:
For example:
You have $600 budgeted to pay toward your debt.
Here are the bills you have:
Credit Card: $2,000 at 18% APR, $50 minimum payment
Low-Interest Credit Card: $10,000 at 6% APR, $150 minimum payment
Personal Loan: $6,000 at 5.5% APR, $100 minimum payment
If you were using the Snowball Method, you would still make all of your minimum payments to each of your bills, and you would put any extra funds you had budgeted toward debt repayment toward the smallest bill. So, you'd put a total of $300 to your minimum payments. Then you'd put the additional $300 you have in your $600 debt repayment budget to the $2,000 Credit Card bill first. Once that credit card is paid off, you'd start putting additional funds toward the personal loan because it's the next smallest bill. After paying both of those off, you'd move on to the low-interest credit card.
The benefit of the Snowball Method is that it can feel motivating to see some of those smaller bills go away sooner. This method has worked for many people working their way out of debt because it can be more motivating. The disadvantage of the Snowball Method is that you will pay more in interest, and it is likely to take you more time to pay all of your bills off. That said, for many, the motivation from seeing bills go away sooner is what drives them to the Snowball Method and helps them successfully pay off all their debt.
Debt Consolidation
Another common strategy for paying down debt is debt consolidation. Debt consolidation is when you take all of your different bills and use a loan or a credit card to pay them off, so you have one bill with one interest rate. Debt consolidation can take many different forms from unsecured loans, to using equity in your vehicle or home for your consolidation loan. What option works best for you depends entirely on your financial situation, and we encourage you to speak to a loan officer to get more details on what options may be available to you.
While debt consolidation may seem attractive because it simplifies your situation, there are several factors to consider, including potential impacts to your credit score and analysis of your own behavior with spending and debt. We know that most of us aren't in debt because we're big spenders. Frequently it's because of student loans or unexpected medical expenses. That said, if you've been struggling to pay down your debt or are in debt because of your spending habits, you may need to make some lifestyle adjustments to avoid future debt.
There is no one size fits all answer to paying off debt. Getting started is sometimes the hardest part, but once you have your plan in place, you'll feel much more confident in your debt repayment strategy. If you need more personalized assistance with paying down your debt, contact our partner GreenPath Financial Wellness.
