What’s the Right Way to Pay Off Debt?

paying off debt

When you get right down to it, any way you go about paying off debt is going to be a positive thing. So, do not let confusion over specific debt-reduction strategies get in the way of taking action. But, there are nearly as many different ways to get out of debt as there are to get into it, so it makes sense to consider the various alternatives and determine which method makes the most sense for you.

For the sake of this discussion, we are limiting the topic to actual debt-reduction strategies that rely on using your own income to fully pay off your legitimate debt. That is not to say that other options for eliminating debt are not worth considering. Depending on your circumstances, these can include negotiating debt with your creditors or even declaring bankruptcy.

We are also not discussing methods of consolidating, refinancing, borrowing against other assets, or otherwise replacing your existing debt with another form of debt, although these, too, have their place in every smart consumer’s book of options.

So, the rest of this article is going to focus on the three most popular and effective strategies for actually eliminating your debt, the pros and cons of each, and why you may choose one over the others.

The Avalanche Method

As defined by Investopedia, the “avalanche method” of debt reduction is, “A method of repaying debts in which a debtor allots enough money to make the minimum payment on each debt, then devotes any remaining debt-repayment funds to repaying the debt with the highest interest rate. Using the debt avalanche method, once the debt with the highest interest rate is completely paid off, the extra repayment funds go toward the next highest interest-bearing debt. This process continues until all the debts are paid off.”

To illustrate, imagine you have four separate debts you are working to pay off:

  • A credit card with a $3,000 balance, $50 minimum payment, and a 22 percent interest rate
  • A car loan with a $7,500 balance, $250 minimum payment, and a 6 percent interest rate
  • A home equity loan (HEL) with a $12,000 balance, $100 minimum payment, and a 8 percent interest rate
  • A personal loan with a $800 balance, $25 minimum payment, and a 15 percent interest rate

Using the avalanche method with this debt profile, you would pay just the minimum payment on every account you are paying off except for the account with the highest interest rate (in this case, the credit card.) So $375 of your $500 budgeted debt payments would go to the car loan, HEL, and personal loan, and the remaining $125 would go toward the credit card.

As time goes on and the highest interest account is completely paid off, you would continue making the minimum payments on all but the next highest interest balance, and move the remaining balance of your $500 to paying off that account. This continues on down the line until all the debt is gone.

Using these figures, and assuming you are not increasing any of these debts, here’s what it would cost you and how long it would take to eliminate all this debt using the avalanche method:

 

Account Time Until Paid Off Total Interest Cost
Credit Card 32  months $1,001.30
Personal Loan 32 months $216.92
Home Equity Loan 57 months $3,548.68
Car Loan 32 months $646.40
Total 57 months $5,413.12

 

From strictly a financial perspective, this is the best strategy you can use. That is because it focuses first and foremost on eliminating the actual cost of your debt — the interest payments — as quickly and efficiently as possible. So, in the long run, the avalanche method will always save you the most money.

But, that is only if you have the self-discipline to truly stick with it, month after month. And, that is why the other two methods are even more popular.

The Snowball Method

Made famous by personal finance guru, Dave Ramsey, the snowball method combines the payment strategy of the avalanche with a twist that’s based in human psychology:

Rather than starting with the debt with the highest interest rate, the snowball method starts by attacking the account with the lowest balance and works up towards the largest accounts. This can be powerful because of its potential motivational impact. By starting out paying down the smallest balance first, you establish what Ramsey calls “momentum” — basically a feeling of accomplishment that encourages you to keep at it — which can make it easier to stay motivated and disciplined over the long haul.

In fact, a study conducted by HelloWallet and the Harvard Business School determined that people using the snowball method paid off their debts 15 percent faster than those who split up their budget equally.

Compared to the avalanche method, the snowball method will almost always cost more in total interest, but when compared to its motivational power and the increased compliance that comes with it, most debtors find that a small price to pay. Still, you should research the numbers before making a final decision between the two.

Using the same scenario described above, this is how the numbers look using the snowball method:

Account Time Until Paid Off Total Interest Cost
Personal Loan 7  months $39.44
Credit Card 33 months $1,294.05
Car Loan 32  months $646.40
Home Equity Loan 57  months $3,568.66
Total 57 months $5,548.54

 

The Equality Method

The final method is definitely the easiest to manage and does a fair job of balancing out the “interest vs time” argument that rages among proponents of the other two methods described above.

Basically, using the equality method, you again start with a budget and simply divide that amount up evenly among all your debts, regardless of minimum payments, balances or interest rates. That way, you’re working on paying all of them down at once, and you can easily use a “set it and forget it” bill pay arrangement to automate your debt reduction.

In a perfect world, you could always divide it evenly, but one of the downfalls of the equality method is clear looking at our example (which is pretty typical of real world debt reduction situations.) The minimum payment for the car loan requires an outsized piece of the pie. And, once that’s covered, it also puts the home equity loan’s minimum payment above the amount that can be relegated to cover it.

That is why the equality method is only practical in circumstances where someone is highly motivated and willing to do whatever is necessary to commit to a very high budgeted monthly payment toward debt reduction. For instance, if the same creditor we’ve been discussing made a number of difficult sacrifices and vowed to apply $1000 toward debt reduction per month, they would be able to use the equality method successfully, with the following results:

 

Account Time Until Paid Off Total Interest Cost
Personal Loan 4  months $21.64
Credit Card 11  months $357.63
Car Loan 21  months $449.58
Home Equity Loan 40  months $1,355.44
Total 40  months $2,184.29

 

In Conclusion…

So, after discussing all three of these popular methods for paying off debt, what’s the best option for you?

Look at it this way:

  • If you have plenty of money to spend every month toward eliminating your debt, the equality method is both the fastest and cheapest way to go.
  • If you have a limited amount (above and beyond the minimum payments) to spend, the snowball method will cost a little more in the long run, but it has a better success rate because it’s easier to stay motivated.
  • If you are highly motivated by saving the very most money, then spend your limited budget using the avalanche method and you will save the most on interest over time.

But, what if you are so deep in debt that even making all the minimum payments is too much? That’s where you would do well to work with credit repair and personal finance professionals to see what options are available to you for reducing or consolidating your debt to get those payments down to a point where you can start applying one of the three above methods to finally paying it all off.

Contact Lexington Law today if you would like to speak to an expert in credit law.

 

 

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