Car payments. Mortgages. Home equity lines. Student loans. Credit cards. The list goes on for the common types of debts people owe. We live in a world that runs and relies heavily on debt from our own governments to most businesses, down to individual citizens and families. In all likelihood, you currently hold some form of debt. The more debts you hold, the more confused you might feel about how to go about addressing it. All the while you are accruing more and more interest and you feel more and more paralyzed about your situation.
Paying off debt is not easy. You may regret the debts you now have, and you may not. There was probably a justifiable reason for why you needed it at the time, but there’s also a good chance you didn’t expect to end up owing as much as you do now compared to when you started. So, where do you go from here? Do you pay off credit card debt first? Then your car? Then your house? Do you wait for yet another politician to promise he will erase your student loans?
There are a couple of different methods for tackling debt. I’ll go through some of them now, highlighting what I think are the strengths and weaknesses of each.
The Snowball Method
I reference Dave Ramsey probably more than anyone else on this blog. I can assure you that his advice has been instrumental in setting me on the right path and I’m sure than many others around the world would agree with me. One of his famous teachings is the debt snowball technique. It doesn’t involve paying off debts based on what type they are or what interest rate they have necessarily. But rather, he suggests paying off the debts with the lowest balances first, one at a time, and working your way up to the larger balances at the end. This is why it’s a snowball. You start off small and then roll that ball around in your yard until you have enough to build a giant snowman. It’s a way of slowly building momentum that is especially needed when you feel trapped by your debts. Without any sense of momentum, you’re not likely to get very far.
This technique only involves a few steps. You begin by listing all of your debts from smallest to largest, regardless of interest rate. Here’s an example:
- Credit card 1: $1,345
- Credit card 2: $2,678
- Car loan: $7,414
- Subsidized student loan: $11,832
In total, $23,269 is debt burden across all four of those. Close to half of that is strictly the student loan, so wouldn’t pay that off first make the most sense?
Not quite, according to Ramsey. Once you are positioned to make the minimum monthly payments on each of these debts (make sure to add those into your monthly budget from now on), you can start throwing money at the balance of the smallest one first. Think about it this way: paying off one debt in its entirety will feel very liberating, as people who have gotten out of debt would often agree. It will take much less time to pay off the $1,345 owed on the first credit card than the $11,832 owed on the student loan. Once you paid that off, you now have 3 debts remaining instead of 4 and you got there as quickly as you could. Move on down the list, be consistent, and you will eventually reach the end of the list.
Again, this technique is not my own, though I highly recommend it. See Ramsey Solutions’ website for more information on this method.
The Avalanche Method
In contrast to the snowball method is the avalanche method. It’s not necessarily the complete opposite, as it doesn’t suggest paying off each debt in order of balance size. Rather, it prioritizes paying off each debt from the ones with the largest rate to the one with the smallest interest rate. In many ways, it is the most mathematically sound because you are likely to end up paying the least in terms of dollars over the course of this process. So, if the above debts were paid off according to their interest rates, you could go in this order:
- Credit Card 2: $2,678 (24.3% interest)
- Credit Card 1: $1,345 (18.6% interest)
- Car loan: $7,414 (9.2% interest)
- Subsidized student loan: $11,832 (7.1% interest)
In this example, the payoff order will ultimately not make a huge difference, as you are simply reversing the order of the credit cards, both of which should be paid off relatively quickly compared to the car and the student loan. But you can certainly imagine many scenarios in which the number of debts with varying balances is far more complex than this relatively simple example.
Between these two, I’d say deciding which one is better will depend on what matters more to you: saving every dollar possible or a gradual sense of accomplishment. The avalanche method can theoretically get you out of debt quicker because of its emphasis on targeting faster growing debts first, but the snowball method might ultimately get you there quicker because you are less likely to give up if you gain that sense of accomplishment earlier on. The reality is that paying off debt is extremely challenging, which is why most people end up staying in debt. Whichever method brings you greater satisfaction is likely to ultimately be the one for you.
Debt Consolidation
Debt consolidation is another method for paying off your debts, though it is not always possible. It works by combining all of your debts (presumably you have several) into a single account. That way, you have one balance to keep track of and only one place to send your payments as you watch that balance whittle itself down until it reaches $0.
This method can be useful for certain situations. For example, you might have multiple student loans of varying balances to keep track of. Refinancing is the process of consolidating all of those student loans into a joint balance with one interest rate that all of the previous loans will now fall under. It’s much simpler to do this with loans of the same type, such as these. However, consolidating student loans with other types of debt, such as car loans, medical bills, and credit cards, usually involves taking out a new loan that will absorb the previous ones. I don’t have much knowledge or experience in using this method so I can’t say much else on it. In general, I do believe the snowball and avalanche methods are possible for the vast majority of people trying to get out of debt. But consolidation, along with other less well-known methods, are available to you as well.
Paying off debt is a huge step forward to gaining financial independence. Unfortunately, our world today has gotten so used to paying for nearly everything with debt that many people don’t even question why they should continue that cycle in the first place. Some believe it is impossible to live without debt. It isn’t. Research the stories of people out there who got themselves out of deep financial holes and you will see what I mean. If it is possible for them, it is possible for you. Don’t lose sight of that vision you have for your own independence. Never let anyone take it from you.
That’s all for now. Peace!
