Paying Off Debt: What’s the Best Strategy?
Like many people, you’ve found yourself with too much debt and you want it gone. It can seem like a daunting task, and you may wonder what the best way is to pay off debt when you don’t have enough savings to eliminate it all at once.
The first step to consider is to work with your creditors to see if you qualify for a lower interest rate. You may also consider transferring balances to creditors who will offer you a lower rate, or consolidating your debt, which is combining your balances into one payment, preferably at a lower interest rate.
When paying down debt, there are two general payment strategies suggested by financial experts, often referred to as the avalanche strategy and the snowball strategy. It’s important to pick the one that fits your finances as well as what motivates you to succeed. You can do it if you stick to your plan.
The following is a basic outline of the strategies to pay off debt that has several different interest rates—they do not include home loans. Here’s how the strategies work:
This strategy targets debt with the highest interest rate first. Make minimum payments on the debt with the lower rates so you don’t incur charges or fees, and use all remaining available money to pay as much as you can on the debt with the highest interest rate. Once you’ve paid off the highest-rate debt, you move to the next-highest rate, adding the payment amount to from the debt you just paid off. So, for example, if you were paying $500 a month on the debt you just eliminated and a $100 minimum payment on the next debt you will be paying off, combine the two and pay $600 a month until that debt is eliminated. Each time you eliminate an obligation, you add that monthly payment to the minimum amount of the next payoff target.
The snowball strategy focuses on the amount of money you owe each creditor, disregarding the interest rate. Pay as much as you can on the debt with the lowest balance and pay minimum amounts on all your other debt each month. Once you pay off the first debt, add that payment to what you were paying on the debt with the next-lowest balance until that one is paid off. Continue with this strategy for each successive obligation until you are debt free.
Which is best?
Which of these two methods is right for you? It depends. Financially, depending on the amount you owe, you will pay less money overall using the avalanche method. You will also likely be debt-free sooner, again depending on the total amount you owe.
So why use the snowball method if it costs more over the long term? Some experts believe that by paying off the lowest balance(s) first you create a sense of accomplishment by eliminating a specific debt, and that builds momentum to whittle away at more debt since you’ve seen tangible progress. For example, you may have a credit card with a balance of $500 and others with much higher balances. By quickly eliminating the $500 card, you see progress right away. So, while this approach provides more motivation, you will pay more in the long term because you are still accruing interest on the higher-rate debt.
Whichever method works best for you, the key is to stick with it to build a stronger financial future. If you are ready to become debt free and need help getting started, reach out to your banker for help with a strategy to succeed.