Getting out of debt is one of the best possible things you can do for your finances. Paying off everything (except a mortgage) as quickly as you can will allow you to free up money to spend, save for goals, or invest for retirement. Or, ideally, all of the above. But how do you do it? You need to prioritize by deciding which system is better for you, the Avalanche or the Snowball?
The Debt Avalanche: Best Savings
Both systems work similarly, but they are organized differently. If you want to save as much money as possible during your repayment, the Avalanche is your friend. In order to pay off your debts, you are going to target them one at a time based on their interest-rate. We start with the highest interest-rate in this system and pay off the next-highest next and so on until their gone. By taking care of the highest interest-rates first, we reduce the total interest we pay on our debt.
The debt snowball: Best Psychology
Paying off debt isn’t a fast process. It can last for years, and you need to stay motivated during the process or it won’t work. Enter the Debt Snowball, originally developed by Dave Ramsey. Instead of organizing by interest-rate, in the Snowball, we organize by balances, from lowest to highest. This gives us a couple quick wins at the beginning. You might not think that’s a big deal, but trust me, seeing some fast PAID IN FULL labels on your debts is VERY motivating. I still look at my paid in full student loans when I feel like I’m loosing motivation. It reminds me what I’m working towards and keeps me on track. The snowball might not save you the most money, but it will be a similar pay off date and will still reduce how much total money you’re paying. That’s because in either system, you’re paying off the same total amount of debt.
How it works
Don’t spend long deciding between the systems. Just pick on and get going. I’ll demo the a combined approach here.
Let’s say you have the following debts, based on my own when I started to get out of debt:
- 2 credit cards with a total balance around $3,000 and interest rates of 16% and 20% respectively
- A car loan totaling $18,000, with a 60 month term, and charging 4.30% interest
- Student loans totaling $66,000, all charging 6.8% interest, and on a standard 20 year repayment plan
- Total debt: ~$85,000!
Now, I’m using this because it shows that you have to be careful with structuring your Avalanche or Snowball. The car loan has the lowest interest rate, but it’s got to be paid off in 5 years. The student loans are higher-interest, but they have much longer terms for repayment. In this situation, I decided I’d play it safe by moving the car loan to after the credit cards, and before the student loans. This is completely fine. Remember, it might take a couple months longer, but if you’re worried about paying off the car, move it up and take care of it early.
So my priority system went:
- Credit card 1: $2,000, 20% interest, Minimum Payment: $60
- Credit card 2: $1,000, 16% interest, Minimum Payment: $45
- Car loan, $18,000, 4.3% interest, 60 months, Minimum Payment: $333
- Student Loan 1: $11,000, 6.8% interest, 20 years, Minimum Payment, $84
- Student Loan 2: $11,000, 6.8% interest, 20 years, Minimum payment: $84
- Student Loan 3: $23,000, 6.8% interest, 20 years, Minimum Payment: $170.00
- Student Loan 4: $23,000, 6.8% interest, 20 years, Minimum Payment: $170.00
- Total Minimum Payments: $946
Yeah, my debt situation back in 2011 was a mess. Thankfully I’m most of the way done. Of everything, I have 2 student loans left worth $20k. My income as fallen, so they will be paid off in about 5.5. years instead of the 2 I originally hoped. Notice that I went lowest balance on my student loans? I knew they would be long, and they’re all the same interest rate, so I targeted the small ones first to keep motivated.
Now, this is why I talk about budgeting first. You need to make a budget so you know how much extra you can carve out to get this Avalanche/Snowball hybrid rolling. I managed to come up with another $110 a month. Make the minimum payments on all your debts and put that extra money towards your first target.
I targeted my credit cards first. (They were also the smallest balances, so yay for some quick wins!) I put the extra $110 towards Card 1 in addition to it’s $60 minimum. That took 13 months to pay off. Total time elapsed: 1 year, 1 month
Then I took the full $170 I was paying to Card 1 and put it towards card 2 in addition to it’s $45 minimum payment. That card fell in 4 months thanks to the souped up payment and I was officially out of credit card debt. Total time elapsed: 1 year, 5 months
See how this is going? Then take the full $215 that you were paying on Card 2 and put it towards the auto loan in addition to the $333 minimum payment. The car loan was paid off in about a year, a total of 31 months ahead of time on a 60 month loan. Total Time Elapsed: 2 years, 5 months
Then roll the $548 that you paid on the car towards Student Loan 1 and so on. I didn’t get to finish my loans before I left the job and had to change my plan, but over the next 2 years and 7 months I was able to pay off about $46,000 of my $66,000 of student loan debt. There’s only $20k left. Total time elapsed: 5 years.
Notice that we were able to pay off the cards, pay off the car early, and paid off the student loans FAR ahead of their original pay-off dates and saved over $10,000 in interest payments by speeding things up this way. And all I needed was that original extra $110. The rest of those increased payments came from money freed up as we paid off other debts. That’s why this system is so powerful. The more you pay off the faster your remaining payoffs go.
So what are you waiting for? Look back at your budget and see if you can carve out at least an extra $50 or $100 every month. Pick the Avalanche or the Snowball and list your debts out. Use this snowball calculator, and list all your debts in the order you chose. (This calculator respects the order you put them in.) Plug your extra payment in that bottom and it will print out a full schedule for you, showing how long it will take to pay off each debt and what the total going to each debt is by month. You’ll see that while it’s not instantaneous, you can get out of debt far faster than you ever thought.
NOTE: I said I don’t include mortgages in this. That’s because mortgages are enormous compared to other debts and you really want to have a better financial situation before to focus on paying that down. We have a bit more work to do before we can consider paying off a mortgage early. Keep going and we’ll get there.