Now that you’ve assessed your financial situation and have started following a monthly budget, you might be wondering, “What’s next?”. At this point in your journey, paying off all of your debts will be the next task for you to tackle.
If you are anything like us then you probably only want to know what is the best way to pay off debt. In part 3 of our series, we’ll be covering two of the most well-known methods: the Debt Avalanche and the Debt Snowball. We’re also including a secret 3rd method that doesn’t get mentioned very often. (Following these methods helped us become debt free!)
Avalanche Method
In the debt avalanche method, you pay off debts in order of highest interest rate to lowest interest rate, regardless of the balance.
This method is all about the math. In the long run, it can save you the most money by paying off the debts with the highest interest rates first.
During this process, you make the minimum payment on each of your debts except for the debt with the highest interest rate. Put all of your extra money towards that specific debt. Once that debt is gone, you move to the next highest interest rate and repeat the process until everything is paid off.
Do you only have large debts ($1,000+)? With the avalanche approach, you’ll have to wait longer to get the emotional pat on the back that you get after paying off a debt.
Why I love this method: I love saving money…
THE END.
In all seriousness, the way my brains works, I don’t actually care if I spend months chipping away at a large debt with huge interest. Are you also very emotional about money? If so, this method may not be best for you.
Dave Ramsey doesn’t like this method either because he doesn’t believe it is motivating enough to push you through to the finale!
Let’s use Amy & Eric as an example. They owe a combined $41,000 in debt to various creditors. They have decided that they can comfortably afford to put $1,500 towards their debt payments each month.
*Amy & Eric’s debts reorganized according to the debt avalanche method:
Snowball Method
In the debt snowball method, you attack your debts in order of smallest balance to largest balance, regardless of interest.
When you use this method, you make the minimum payment on each of your debts except the debt with the lowest balance. Put all of your extra money towards that debt until it’s paid off. Then, rinse and repeat the process until all of your debts disappear!
This method is more about the psychology of paying off your debts rather than the actual math. Each time you pay off a debt, you get an emotional boost that motivates you to continue the process.
Instead of looking at your debt as one large sum, you see it as a combination of various small amounts. This makes the idea of debt freedom seem more attainable. It ultimately causes your mindset to shift from “I can’t win” to “I can definitely do this”.
*Amy & Eric’s debts reorganized according to the debt snowball method:
Our Secret 3rd Method
Credit cards make up the bulk of the debt in most debt payoff plans. If you find yourself in this category, there is another method you can consider:
Arranging your credit cards in order of highest credit utilization.
Credit utilization is the percentage of your credit that is being used at any given time. You can calculate it by dividing your current balance by your total credit limit ($2,750 bal/$5,000 limit = 55% utilization).
You should strive to keep your credit utilization below 30%. Decreasing your credit utilization has a serious positive impact on your overall credit score because utilization is one of the main factors used to calculate it.
Using this third method will also help you stay motivated because your credit score will begin to increase very quickly. Our scores shot up from the low 600s to well over 750 by taking this approach!
So, what is the best way to pay off debt?
In our experience, we used a combination of all of these methods. We figured out that the best method to use is whichever method works best for your particular situation. At the end of the day, you need to do what works best for you and will keep you motivated throughout the process. Sticking to your financial plan is ultimately most important and any of these methods will help you achieve this goal!
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In the final part of our series we will be talking about Understanding Your Credit Scores. You’ll learn what your credit score is, what is used to calculate it, and what affects it the most.
— Dannie
INFOGRAPHIC
We created the infographic below so that you can share it with friends or save it to use as a quick reference for yourself!
