In this method, you prioritize debt with the highest interest rates. If you have several debts with high-interest rates, you may be losing money even if you pay the minimum payment. This is because the high-interest rate makes you pay more over the course of the debt than if you just paid more than the minimum. This method requires patience and psychological resilience because it will take a while to see results. But it’s well worth it just to take care of the costly interest burden.
Mathematically, the avalanche method will ultimately save you time and money. Logically, it makes sense to pay down the loan that’s the highest in interest rates. But sometimes it’s not as easy as ranking your debt by interest rate. It might be best for you to try the snowball method or a mixture of the two methods instead.
If you have multiple debts with lower interest rates, you should use the snowball method: pay off smaller debts first and then go for the bigger ones. This method has the benefit of giving you a feeling of accomplishment with smaller wins on your way to taking down the largest debt.
For example, you have three loans: a $300 car payment with $30 minimum payment, $5,000 student loan with $500 minimum payment, and $10,000 on medical bills with a $1,000 minimum payment. With the snowball method, you would first make sure you can pay the minimum on all three loans. Then, hit the smallest loan with full payment. You would start with a payment of $300 + $30 + $500 + $1,000 = $1,830. This will get rid of an entire debt in one payment. Your monthly payments will decrease by $30, which you can invest back into paying off your remaining loans. Dave Ramsey, the creator of the snowball method, has more information about his method on his website.
While the avalanche and snowball methods of reducing debt may be opposites, it could be in your favor to combine them. With a hybrid mixture of the two, you will experience easy wins while continuing to pay off higher-interest debts.
Say you have a $10,000 loan with 5% interest (yielding a $42 minimum payment), a $25,000 loan with 3% interest (a $63 minimum payment), and a $2,000 with 55% interest ($92 minimum payment). You’ll want to pay off the $2,000 loan first because it’s the highest interest rate and the lowest debt amount. This will help you roll-over the $92 minimum payment to your next loan: the $25,000 debt. It will take time and hard work to pay off the $25,000 debt, but your last debt ($10,000 loan) will be paid off even faster after you’ve fully paid off $25,000.
BALANCE TRANSFER METHOD
Another method is to essentially mortgage your credit card debt by transferring your balance to another credit card. This works if you have a high-interest rate on your current card and find a lower rate card. You’ll pay less interest over time, so you’ll end up saving money. Some cards offer 0% interest for a limited time, offering a reprieve from paying down interest.
Besides balance transfer fees, which can vary from 3-5%, watch out for hidden fees or clauses about missing payment. The penalties can be severe, and you can end up paying more in the long run simply from paying off extra penalty fees.
CONSOLIDATE YOUR DEBT
Debt consolidation is similar to transferring your credit card balance to another lower interest rate credit card, except it’s for loans. If you have multiple loans, paying off all of them with a single loan can reduce your monthly payments and even lower your overall payment. There are companies online who offer this service. You can also use a local bank, or you can arrange it privately.
When is this is a good option? As with most financial analysis, you’ll have to organize and compile your debt numbers. Find out the total effective interest rate with this equation. Compare that interest rate to the loan you’re considering, including any extra out-of-pocket fees. If the cost is lower with the single loan, you should use it to consolidate your current loans.