A few days ago, BudgetBakers conducted a survey among our user base to find out what are the most pressing personal finance problems that our users are struggling with. Debt and figuring out how to pay it off came first in the list of problems, with over 60% of our users claiming that they needed help with it.
A good percentage of the world is fighting debt. The average American household owes $16,061 in debt; the average per capita debt in the UK is £8000; the average Australian household owes a staggering 212% of their net income in debt; this number is 50% in Asia. Debt also leads to stress that can cause serious medical conditions like hypertension, anxiety, depression, migraines and even digestive problems.
So paying off debt is no easy task. But it is one of the most crucial steps in attaining financial freedom. What you need to get started on your debt repayment journey is a good, practical debt repayment plan.
A good repayment plan will help you keep track of your debt and actually get out of debt faster. But there are many ways in which you can choose to approach this. Here are two ways to pay off your debt and how to choose what is best for you.
Debt avalanche method
The avalanche method of debt repayment focusses on paying off debts with the highest interest rates first. Put simply, this means you make the minimum payments on all your debts, but actively focus on paying off the debt with the highest interest rate first. Many experts love and endorse this method, because it is believed to save you the maximum amount of money when compared to any other method. It helps you get rid of the most costly debts first, thereby helping you save more money in the long run.
Debt snowball method
The next and most popular method of debt repayment is the snowball method. In this method, you start by focussing on paying off the debt with the smallest balance first, irrespective of interest rates. Although on paper, this method would cost you much more in terms of high and continued payment of interest, business researchers and psychologists have found that the snowball method can keep you more motivated as it shows a faster progress rate to closing debts. As you pay off smaller debts, the momentum and motivation to keep paying off your debts and being debt-free increases, say studies.
So how to choose what works for you
To help you find out which of these methods might work better for you, let’s look at an example.
Suppose, you’ve $750 extra to pay towards debt every month, and suppose you’ve three debts:
– $10,000 student loan at 5% interest, with a minimum payment of $150
– $5,000 personal loan at 3% interest, with a minimum payment of $70, and
– $9,000 credit card debt at 20% interest, with a minimum payment of $250
This means that you’ve $24,000 in debt and have to pay $470 in minimum payments.
Using the debt avalanche method,
You will pay off your credit card debt first, which means that you’ll put the $280 remaining after making minimum payments to paying off this debt first. Once, this debt is paid off, you’ll put the extra money into paying off the student loan and finally the personal loan with the least interest rate.
So, using the debt avalanche method, you’ll be debt free in 36 months and pay a total of $26,919.
Now, using the debt snowball method,
You’ll direct the extra $280 towards paying off your personal loan, then the credit card debt and finally your student loan.
Using the debt snowball method, you’ll be debt-free in 38 months and pay a total of $28182.
So the debt avalanche method saves you $1263 and gets you out of debt 2 months earlier.
To find out how quickly you can pay off your debt using these two methods, use this handy debt repayment calculator.
So does this mean that the avalanche method is better?
At first glance, $1263 seems like a lot of money saved. But, the difference in interest is only $25 a month.
Also, many a study has shown that most people care about not how much money they were left with after paying towards their debt or how much they saved, but they were worried only about how much percentage of their debt they ended up getting rid of.
This means that if you have two debts amounting to $1000 and $500, repaying $400 of the $500 debt would make you feel more motivated and happier than splitting it into two and repaying $200 of both the debts. Although you repay the same amount, the former makes you feel more accomplished because you paid off almost 90% of one of your debts.
So there will always be arguments for and against both these methods of debt repayments. Making a choice between the two then boils down to your personal preference.
The avalanche method would suit you, if:
-Your main goal is saving interest money.
-You are self-disciplined.
-You are driven to pay off your debt and are not looking for instant gratification or motivation to stay on track.
The snowball method would suit you, if:
-You are motivated by quick wins.
-You aren’t worried about paying a bit extra in the long run to stay motivated.
-You need to see immediate results and progress to keep you going.
As is with any personal finance decision, you must stick to a practical method that works for you and your money and not adopt something just because it worked wonders for others.
And, never go into additional debt to pay off your existing debts. Instead, start cutting down spending and saving to pay off your loans. As you pay off your debt, do not forget to start building your emergency fund. This will make sure that you don’t fall into the vicious circle of piling on more debt, without having paid off existing ones.
Over to you
What is your preferred debt repayment strategy? Or, do you use one that is not mentioned here? Let us know your ideas in the comments section below.