The Best Ways to Pay Off Your Debt

The Best Ways to Pay Off Your Debt

The best way to pay off your short-term and revolving debt depends on your priorities and what motivates you.  Two of the common approaches for determining the order in which to re-pay your loans discussed in financial literacy circles are the Debt Snowball and Debt Avalanche approaches.

Both of these methods apply when you have more than one debt that needs to be re-paid.  If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, making the minimum payments as often as you can to avoid finance charges which will be added to your principal in addition to the interest charges on any portion of your balance you don’t pay.

In this post, I’ll describe how the two debt-repayment methods work using some illustrations.  I will then help you understand which approach might be better for you.  For more information about the fundamentals of debt, check out my posts on loans and credit cards.

What’s Included and What’s Not

The debts covered by this post include credit cards (one kind of revolving debt), personal loans, car loans and other bills that are overdue. While longer-term loans, such as mortgages, are referenced in the budgeting process, I haven’t included them in the debt re-payment examples. If you have unpaid short-term debt, you’ll want to keep up with the payments on these longer-term loans first, but don’t need to pre-pay them. For this discussion, I will assume that you intend to re-pay all of your debts to your current debtholders. That is, you haven’t dug a hole so deep you need to declare bankruptcy and you don’t feel you’ll benefit from transferring some or all of your high-interest rate loan balances to one with a lower interest (i.e., debt consolidation).

Debt Snowball

Dave Ramsay, a well-known author on financial literacy topics, proposed the Debt Snowball method for paying off your debts.  Under this method, you do the following:

  1. Identify all of your debts, including the amounts of the minimum payments.
  2. Make a budget. (See this post for more on budgeting generally or this one for the first of a step-by-step series on budgeting including a helpful spreadsheet.) Your budget should include all of your expenses excluding your short-term and revolving debts but including the payments you plan to make on your longer-term debts (e.g., car loans and mortgages).
  3. Determine the total amount left in your budget available to re-pay your debts, remembering that you need to be able to pay for the total cost of all of your current purchases before you start paying off the balances on your existing debt. If the amount available to re-pay debts is less than the total of your minimum payments, you may need to look into your options to consolidate or re-structure your debts, get them forgiven or declare bankruptcy.
  4. Otherwise, make the minimum payment on all of your debts except the smallest one.
  5. Take everything left over in your budget from step (3) and reduce it by the sum of the minimum payments in step (4). Use that balance to pay off your smallest debt. After you fully re-pay the smallest debt, you’ll apply the remainder to the next smallest debt and so on.

Debt Avalanche

The Debt Avalanche method is very similar to the Debt Snowball method, except you re-pay your debts in a different order.

The first three steps under the Debt Avalanche method are the same as the first three steps under the Debt Snowball method.  It differs from the Debt Snowball method in that you pay the minimum payment on all of your debts except the one with the highest interest rate at any given time instead of the one with the smallest balance.

Examples

I’ve created the two examples to compare the two methods.  In both examples, I have assumed that you use a different credit card or pay cash for all new purchases until your current credit card balances are re-paid.  That is, to make progress on getting out of debt, you need to not only make extra payments on your existing debts, but also not create additional debt by borrowing to pay for new purchases.  It’s tough!

Example 1

In this example, you have two debts with the balances due, interest rates and minimum payments shown in the table below.

Example 1 Balance Due Interest Rate Minimum Payment
Debt 1 $1,500 20% $30
Debt 2 500 10% 10

You have determined you have  $100 available to pay off these two debts.  The minimum payments total $40 in this example, so you have $60 available to pay off more of the principal on your debts.

Example 1: Debt Snowball

Under the Debt Snowball method, you will use the additional $60 a month you have to pay off Debt 2 first, as it has the smaller balance.  That is, you will pay the minimum payment of $30 a month on Debt 1 and $70 a month on Debt 2 for 8 months, at which point Debt 2 will be fully re-paid.  You will then apply the full $100 a month to Debt 1 for the next 17 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 25 months and will pay $428 in interest charges.

Example 1:  Debt Avalanche

In Example 1, you will use the additional $60 a month you have to pay off Debt 1 first under the Debt Avalanche method, as it has the higher interest rate, whereas you used the additional amount to pay off Debt 2 first under the Debt Snowball method.  That is, you will pay the minimum balance of $10 a month on Debt 2 and $90 a month on Debt 1 for 20 months, at which point Debt 1 will be fully re-paid.  You will then apply the full $100 a month to Debt 2 for the next 4 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 24 months and will pay $352 in interest charges.

Example 2

In this example, you have five debts with the balances due, interest rates and minimum payments shown in the table below.

Example 2 Balance Due Interest Rate Minimum Payment
Debt 1 $1,000 10% $40
Debt 2 500 0% 25
Debt 3 10,000 20% 100
Debt 4 3,000 15% 75
Debt 5 750 5% 30

You have $500 available to pay off these debts.  In this example, the minimum payments total $270, so you have $230 available to pay off the principal on your debts in addition to the principal included in the minimum payments.

Example 2: Debt Snowball

Example 2 is a bit more complicated because there are more debts.  As a reminder, under this approach, you apply all of your extra payments ($230 in this example) to the smallest debt at each point in time.  In this example, you will make the additional payments on your debts in the following order:

Debt 2

Debt 5

Debt 1

Debt 4

Debt 3

It takes only two months to pay off Debt 2 and another four months to pay off Debt 4.  As such, you will have fully re-paid two of your debts in six months.  In total, it will take 43 months to re-pay all of your loans and you will pay $5,800 in interest.

Example 2:  Debt Avalanche

In this example, you will make the additional payments on your debts in the following order:

Debt 3

Debt 4

Debt 1

Debt 5

Debt 2

It turns out that Debt 2 is fully re-paid in 20 months even just making the minimum payments.  Debt 5 is paid off 7 months later again with only minimum payments, followed by Debt 1 2 months later.  As each of these debts is re-paid, the amounts of their minimum payments are added to the payment on Debt 3 until it is fully re-paid after 39 months.  At that point, the full $500 a month is applied towards Debt 4 which then takes only 2 additional months to fully re-pay.  In total, it will take 41 months to re-pay all of your loans and you will pay $5,094 in interest.

Comparison

Dollars and Sense – Two Examples

Looking at the two examples, we can get a sense for how much more interest you will pay if you use the Debt Snowball method instead of the Debt Avalanche method.  The table below compares the two methods under both examples.

Example 1 Example 2
Interest Paid Months of Payments Interest Paid Months of Payments
Snowball $428 25 $5,800 43
Avalanche 352 24 5,094 41
Difference 74 1 706 2

In these two examples, you pay more than 10% more interest if you use the Debt Snowball method than the Debt Avalanche method, leading to one or two additional months before your debts are fully re-paid.

Dollars and Sense – In General

The difference in the amount of additional interest depends on whether your debts are similar in size and the differences in the interest rates.  I’ll take that statement apart to help you understand it.

  • If the debt with the lower interest rate is very small, you will pay it off quickly.  As a result, there is only a very short period of time during which you are paying the higher interest on the larger loan under the Debt Snowball method.  As such, there will be very little difference in the total amount of interest paid between the two methods in that case.
  • If the debts all have about the same interest rate, it doesn’t really matter which one you re-pay first, as the interest charges on that first loan will be very similar to the interest charges on your other loans.

Dollars and Sense – Illustration

The graph below illustrates the impact of the differences in interest rates and sizes of two loans on the difference in the total interest paid.  To create this graph, I took different variations of Example 1.  That is, you have two loans with outstanding balances totaling $2,000 and the interest rate on the larger debt is 20%.

 

How to Read the Axes

The interest rate on the smaller loan was calculated as 20% minus the increment shown on the axis labeled on the right.  That is, the interest rate on the smaller loan for scenarios near the “front” of the graph was 18% or 2 percentage points lower than the 20% interest rate on the larger loan.  Near the “back” of the graph, the interest rate on the smaller loan is 0% or 20 percentage points lower than the interest rate on the larger loan.

The loan balance on the smaller loan divided by the total debt amount of $2,000 is shown on the axis that goes from left to right.  The small loan is $40 (2% of $2,000) at the far left of the graph and increases as you move to the right to $960 (48% of $2,000) on the far right.  Note that, if the small loan exceeded $1,000, it would have become the bigger loan!

The Green Curve

The green curve corresponds to the total interest paid using the Debt Snowball method minus the total interest paid using the Debt Avalanche method.  For example, at the front left, corresponding to the small loan being $40 with an 18% (=20% – 2%) interest rate, there is a $2 difference in the amount of interest paid.  At the other extreme, in the back right of the graph (0% interest rate on a small loan with a balance of $960), you will pay $167 more in interest ($308 versus $140 or more than twice as much) if you use the Debt Snowball method rather than the Debt Avalanche method.

What It Means

Interestingly, moving along only one axis – that is, only decreasing the interest rate on the small loan or only increasing the size of the smaller loan – doesn’t make very much difference.  In the back left and front right, the interest rate differences are only $15 and $22, respectively.  The savings from the Debt Avalanche method becomes most important when there is a large difference in the interest rates on the loans and the outstanding balances on the loans are similar in size.

Sense of Accomplishment

For many people, debt is an emotional or “mental-state” issue rather than a financial problem.  In those situations, it is more important to gain a sense of accomplishment than it is to save money on interest.  If you are one of those people  and have one or more small debts that you can fully re-pay fairly quickly (such as Debts 2 and 5 in Example 2 both of which were paid off in six months under the Debt Snowball method), using the Debt Snowball method is likely to be much more successful.

Key Points

Here are the key points from this post:

  • A budget will help you figure out how much you can afford to apply to your debts each month.
  • If you can’t cover your minimum payments, you’ll need to consider some form of consolidation, re-financing or even bankruptcy, none of which are covered in this post.
  • If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, but making the minimum payments as often as you can to avoid finance charges.
  • You will always pay at least as much, and often more, interest when you use the Debt Snowball method as compared to the Debt Avalanche method.
  • Unless you have two or more debts that are all about the same size and have widely varying interest rates, the total interest you will pay is essentially the same regardless of the order in which you re-pay them.  As such, if the sense of accomplishment you get from paying off a few debts will help keep you motivated, using the Debt Snowball method may be the right choice for you.
  • If you have two or more debts that are all about the same size and have disparate interest rates, you will want to use the Debt Avalanche Approach.  Because the balances are all about the same, it will take about the same amount of time to re-pay the first loan regardless of which loan you choose to re-pay first!  As such, it is better to focus on the interest you will save by using the Debt Avalanche approach.

 

The Scoop on Credit Scores

Credit scores are one of the most important financial numbers.  Credit scores not only affect the interest rate you pay when you borrow, but also your ability to borrow and other important financial transactions. It has been a long time since I’ve borrowed money, so I talked to Cody Jensen, a consumer loan officer at Missoula Federal Credit Union, to get the most current information.  In his role as a loan officer, Cody spends a lot of time educating young borrowers, so he was a terrific resource.  Here is a summary of the interview (with a few tidbits I found on line to expand on a few of his points).

What are Credit Scores?

Most lenders and vendors use the national score calculated by Fair Isaac Company.  It is a number between 300 and 850 that measures your creditworthiness and is sometimes called FICO score.

How are They Used?

Your credit score affects whether you can get a loan (see this post for more about loans) and, if so, the interest rate you will pay.  The lower your credit score, the higher the interest rate you will be charged.

Your credit score also impacts other financial transactions, such as:

  • Landlords use it to evaluate whether to rent to you.
  • The amount that you will pay if you lease a car (see this here for more on leases).
  • Most companies issuing you a contract, such as cell phone providers and cable companies, use it to decide whether you have to pre-pay for your services. That is, if you don’t have a high enough credit score, you will need to pay in advance for your services or make a significant deposit.
  • In many jurisdictions, car and homeowners/renters insurers use it as a rating variable. The lower your credit score, the higher the insurance premium you will have to pay, all other things being equal.

What is a Good Credit Score?

The thresholds vary between categories depending on the user of the information. The chart below shows the approximate distinctions considered by many vendors.

What Determines My Credit Score?

According to Investopedia, there are five factors that determine your credit score:

  • Payment history – Do you pay your bills on time. Timely payment for a long period of time will improve your credit score.
  • Credit utilization – The ratio of the amount you owe to your credit limit on credit cards.While you want a score that is more than 0% (i.e., using your credit cards is good), as the ratio increases above 30% your credit rating will decrease.
  • Length of credit history – The length of time you have used credit, either through student loans, other loans or credit cards. The longer you have used credit, the higher your score will be.
  • New credit – The amount of recent increases to your credit (e.g., new credit cards or loans). Once you have established credit, taking on additional loans or credit cards will lower your score.
  • Credit mix – The types of credit you use. Using different types of credit, such as loans and credit cards, improves your score.

The chart below shows the weights given to each of these factors.

What Can I Do to Improve my Credit Score?

Whether you are just getting started with credit or have an established credit history, here are some things you can do to improve or maintain your credit score:

  • Pay your bills on time. As indicated above, paying at least the minimum payment on your credit cards and making your full installments on any loans by their due date combine to be the biggest contributor to your credit score.
  • Wait until you have a couple of years of experience on your record. By taking the time to establish your credit experience before taking out a loan, you can reduce your interest rate or increase your ability to get a loan.
  • Get a secured credit card. If you are just getting started or need to re-build your credit, you can use this type of credit card.
    • When you open the account, you need to put down a security deposit that is higher than the limit on the credit card, often 110% of the credit limit. For example, if you get a card with a $1,000 credit limit, you’ll need to give the issuer a security deposit of $1,100.  This deposit will be returned when you close the account.
    • Ask someone else to co-sign on the credit card. In this case, the card becomes a shared secured credit card.
    • To improve your credit score, you’ll want to pay off all your charges every month.
    • You will establish a strong payment history, which improves your credit score, by using the secured credit card regularly for a period of time.
    • A secured credit card doesn’t count as a loan so it doesn’t hurt the credit utilization part of your credit score.
  • Make sure there is a balance on your credit card on the last day of the calendar month.
    • That’s when FICO checks your balance, so it is the date on which credit utilization is calculated.
    • You can then pay it off when your bill is due to improve your payment history and avoid interest payments.
    • You score will improve if your balance is between 3% and 30% of your limit on the last day of the month.
  • Check your credit information as maintained by the credit bureaus (Equifax, Experian and TransUnion). This information includes all of your loans and credit cards, your outstanding balance at the end of each month and your payment history.  You are allowed to request your credit report (but not your credit score) for free from each bureau once a year.  If you want it more often than that, you need to pay a fee. You can either enter the information on Annual Credit Report.com’s web site or print a form and submit it by snail mail.  I know a few people who have found mistakes (usually due to identity theft or confusion with a person with a similar name) that have hurt their credit scores. There is a process by which your credit report can be corrected, though it isn’t always easy.

What Are the Causes of Low Credit Scores?

Obviously, not paying your credit card bills or re-paying loans will lower your credit score.  Other factors that can lead to a lower credit score are:

  • Late payments. Again, whether you make your payments on time is the biggest factor in determining your credit score.
  • Too much debt (including credit cards and student loans). If you take on too much debt, you are less likely to be able to re-pay it.  When you have so much debt you can’t keep up with your payments, credit utilization will be too high and payment history could become poor.  These two factors alone drive 65% of your credit score.
  • While a divorce itself does not lower your credit score, some aspects of unwinding the finances can put downward pressure on credit scores.  In many marriages, the couple acquires debt based on their combined income.  For example, many couples rely on both incomes to secure a mortgage for a home.  If the couple gets divorced, they now need two households and neither one has sufficient income to pay off their joint mortgage or other debts.

How Do I Find Out My Credit Score?

Many banks and credit card companies will provide you with your credit score for free.  When I log into my bank’s web site, I can see my FICO score.  You can also pay one of the major credit bureaus (Equifax, Experian and TransUnion) for your credit score.