Ok, so you’ve come to terms with the debt you have, and you have some extra money in your cash flow to allocate toward extra debt payments. Now the question becomes: What debt-reduction strategy is actually best? There are a few debt-reduction strategies you can follow, but the Snowball and Avalanche methods are the most popular.
The Snowball Method:
This is what personal finance and debt-reduction guru Dave Ramsey preaches. With this strategy, you start by paying the minimum on all debts and allocate additional debt payments toward the debt with the lowest balance. This approach allows for immediate gratification and motivates you to keep paying off your debts. But because the debt with the lowest balance isn’t necessarily the one with the lowest interest rate, you might not save as much interest over time this way. However, since a lot of financial success comes from your behavior, this method produces some quick wins–which may help you stay motivated over the long haul. Also, since the cards with the lowest balances get knocked off first, this method lets you focus all of your extra cash on the bigger accounts.
The Avalanche Method:
Here, you allocate any additional debt payments to the debt with the highest interest rate (most likely a credit card), while paying the minimums on the rest. You continue chipping away at the most expensive debt until it’s completely paid off. Then you move to the next-highest interest rate debt and allocate any additional debt payments to it. Mathematically speaking, this strategy saves you the most money over time, since you pay the higher-interest debts before lower-interest ones. However, it may not allow for the immediate gratification of the Snowball Method.
So which is better? Well, I usually encourage clients to follow a combination of both methods. Start by paying off the debt with the lowest balance, then move on to the debts with the higher interest rates and continue to stick to the Avalanche Method from that point forward.
Here is an example:
Let’s say that you have a credit card with a balance of $900 and high 23% interest rate, $5,000 on an auto loan at 3.5% and $30,000 in student loans at 6%. You recently got a raise at work or extra freelance work this month, and have extra money to use toward making additional debt payments. Following either method, you can see that paying off the credit card first is the best decision as it has both the lowest balance and highest interest rate. From there, you can move on to making additional payments toward the student loan while paying the minimum on the car loan.
And of course, it’s best to work with a financial advisor who can help you design a strategy that is comfortable and efficient for you.
This post was contributed by Brittney Castro, CFP®, Founder and CEO of www.FinanciallyWiseWomen.com. Follow her on twitter @brittneycastro. Brittney Castro is not affiliated with TheEverygirl.com. Brittney A. Castro is a registered representative with and securities offered through LPL Financial, Member FINRA/SIPC. California Insurance License #0F33895. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.