Sadly, debt is rampant in America, with each household in America holding an average of higher than $8,000 in credit debt, and United States total consumer debt is more than $13 trillion. Debt, of course, can severely damage your financial future, sapping you of valuable resources while negatively impacting your credit score. Many of us are constantly on the hunt for the best way to pay off debt, but may not be aware of what that is. Here is an overview of some of these methods.
The Prep Work
Before you can determine the best way to pay off your debt, you should make sure you know just how much debt you have. As such, gather all your financial documents, and list out your overall debt. A spreadsheet for this may work well, and you should write down information on who you owe the debt to, your interest rate, overall debt, minimum payment, and when the debt should be paid off by.
If you are serious about paying off your debt, you should also redo your budget, eliminating as many expenses as possible and using as much extra money as you can to pay down your debt.
Method 1: The Snowball Method
The Snowball Method is one of the most popular methods of paying off debt. Let’s use the following example:
- Credit Card 1, $4,000 total debt, 10% interest rate, $50 minimum payment
- Credit Card 2, $8,000 total debt, 12% interest rate, $125 minimum payment
- Car Payment, $10,000 total debt, 3% interest rate, $400 minimum payment
- Student Loan Payment, $50,000 total debt, 6% interest rate, $300 minimum payment
- Mortgage, $250,000 total debt, 4% interest rate, $1,200 minimum payment
In this method, you pay your minimum payment of debt on all of your items. However, you would take all of your extra money and use it to pay off the debt that had the total lowest amount. In this case, that would be Credit Card 1. From there, you would take the money you would have paid towards the Credit Card 1 debt and use it to pay off the next smallest debt – which, in this case, would be credit card two. From there, you’d pay off your car, your student loan, and your mortgage.
The benefits of this method are obvious: You can pay off debt and free up more and more cash. That cash can then be used to pay off even more debt, creating a bigger and bigger snowball that can be used to ultimately clear out all of your debt. It also has a psychological benefit: You quickly pay off your debts and can see just how good it feels to free up additional cash. If needed, you can then use this cash for other purposes, like living expenses.
However, there is one drawback to this method: You are not addressing your highest interest first. As such, you may wind up paying more in interest rate and carrying expensive debt for longer periods of time.
Method 2: The Avalanche Method
The Debt Avalanche method also calls for making minimum payments on all of your debt but paying all of your extra money towards the debt with the highest interest, rather than the lowest minimum payment. In the example above, that would mean you pay off Credit Card 2, Credit Card 1, Student Loan Payment, Your Mortgage, and your Car Payment.
This method has the advantage of being able to minimize the amount of money you pay in interest and may enable you to pay off your debt quicker than using the Snowball method. However, you will free up cash at a slower rate than you would using the Snowball method, and depending on your personal financial situation, this may be problematic. Furthermore, it may take a longer time for you to first start to see the results, and for some people, this may create a problem when it comes to paying off their debt and approaching debt removal from a disciplined perspective.
A Modified Approach
These methods should be taken as rough guides. There is no requirement that you stick with one method over another when it comes to removing your debt, and you may find that your personal financial situation demands that you approach a financial situation differently.
For example, in the above example, it would make no sense to attempt to pay off your mortgage payment until last, as that is an exceptionally high amount. Furthermore, there are other considerations to keep in mind besides removing debt. Mortgages have many tax advantages, and their interest rates these days are so low that it is typically wiser to invest in a retirement account and reap the tax benefits of mortgage interest for as long as possible.
As such, keep in mind that debt repayment plans should best fit your personal financial situation. Do not feel pressured to stick with a debt repayment method that may not suit your needs.
Fortunately, if you are interested in getting serious about addressing your debt in one of these methods, you have many options. Many websites are available that allow you to plot out your debt, sort it, and track it. These websites can then be sorted so that you can see what method of repayment works best for you, giving you a variety of projections that can help you determine what method makes the most sense, what modifications you should make, and how to best repay your debt.
As noted above, keep in mind that a spreadsheet shouldn’t be used in exchange for financial planning advice. No spreadsheet can adequately gauge your financial situation, and you should always take the data generated and use it to better inform your decisions – not make them for you.