Student loans, car payments, credit card debt, and the list goes on. The total personal debt across all US households stands at over 14 trillion (yes, trillion!) dollars. Debt can provide leverage to pursue dreams like home ownership and a college degree, but it can also stand as a roadblock to reaching your financial goals.
The COVID-19 pandemic brought—and continues to bring—undue hardship to many American families. One silver lining of our tumultuous 2020, however, was a massive increase in the individual savings rate, a byproduct of which was a focus on reducing household debt. Taking a look at the numbers, American households actually reduced their non-mortgage debt between the first two quarters of 2020, which sounds unremarkable until you see the last time we did that was the beginning of 2011, when we were crawling our way out of the Great Recession.
However, outstanding debt still provides a burden for many US families. When you add up all of the typical debt obligations an individual or household can have, it can seem easier to throw up your hands than tackle the problem. However, there are two tried-and-true methods for beginning to wrangle the various loan payments you may have.
Strategy #1 – The Snowball Method
As the name suggests, this method is all about building momentum to get where you want to go. The snowball method says to pay all your minimum payments but put extra focus on paying off the debt with the smallest balance first. Look at the hypothetical list below:
Type of Debt Balance Interest Rate (APR)
Auto Loan $15,000 4.5%
Credit Card $7,000 22.0%
Student Loan $25,000 5.5%
Personal Loan $5,000 10.0%
With the snowball method you would pay the minimum on everything but try and throw any extra you can muster at the Personal Loan. If your minimum payment on the Personal Loan was $100 per month, try to do $150 to pay it off faster. Once that loan is paid off you roll that payment into the next smallest debt, which is the Credit Card. In this example, if the minimum credit card payment were $50 per month, you would add the $150 Personal Loan payment on top of that for a new monthly payment of $200. Then keep rolling those progressively larger payments into the next biggest loan, like a snowball rolling downhill, until they’re all gone!
Strategy #2 – The Avalanche Method
Whereas the snowball method is all about building the habit of tackling debt by stacking up increasingly bigger wins, the avalanche method is about looking at the numbers and eliminating your most expensive debts first. Looking again at the example from our first strategy:
Type of Debt Balance Interest Rate (APR)
Auto Loan $15,000 4.5%
Credit Card $7,000 22.0%
Student Loan $25,000 5.5%
Personal Loan $5,000 10.0%
Using the avalanche method you’ll also make all your minimum payments, but you’ll throw any extra money you can at the Credit Card debt as it has the highest interest (22%!) attached to it. Once you’ve knocked that one out you prioritize the Personal Loan at 10%, making sure to apply whatever you were paying towards the Credit Card on top of the minimum payment. Rinse and repeat until that Auto Loan is paid off last. The reasoning behind calling it the avalanche method is, like an avalanche, this method can feel like it’s happening very slowly, then all at once. This method also ensures you pay the least interest and pay off your loans the fastest.
Each of these methods work better for different types of individuals, so be sure to keep your own psychology in mind when settling on a debt repayment plan. If you’re the type of person that needs to see progress to stay motivated, then go snowball. If you get satisfaction from paying the least extra interest possible, then avalanche away. The priority is finding something that works for YOU.
It’s also important to keep in mind that you should have an adequate emergency fund on hand before attacking your debt. If you drain your savings to pay off debt but then get hit with an unexpected expense, you may find yourself going right back to the same sources of debt you sought to reduce. Be sure to also involve your financial planner in this discussion as they might recommend other strategies based on your unique situation.
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