Do a quick search for strategies to paying off debt and you’ll find the possibilities are limitless and it seems that everybody and their dog has an opinion.
But if you do some digging, what you’ll find is that all the strategies typically come down to four primary methods.
Each strategy is slightly different.
The four strategies we will be discussing today are: debt snowball, debt avalanche, cash flow method and equal distribution.
To illustrate how each of these examples work, let’s look at Jennifer’s current situation.
Meet Jennifer
Jennifer works a 9-5 job as a marketing consultant and occasionally picks up weekend shifts as a server at a local restaurant. She went to college and currently has $37,000 in student debt with a 6.8% average interest rate.
All through college Jennifer did what she thought was best, took the advice of her parents, friends, and teachers and opened a credit card to help her build credit. She didn’t have an “Oh Sh*t Fund” so when her car broke down, she was desperate and put the repairs on her credit card. As her life grew, she turned to credit cards to help her fund some purchases promising she would pay them back as soon as she could.
On top of that her beater car eventually broke down. Stressed out, she financed a new to her car that was 2 years old, reliable, and even had the little luxuries like heated seats. Total cost of the car? $15,000 with a 4.5% interest rate.
Life happens, right? Even though Jennifer’s story is totally made up, it’s not far from the truth for most people who have debt. We have great intentions, but stuff comes up.
Now Jennifer is ready to make some progress on paying off her debt. (Thank baby Jesus!)
Current Debt Situation
♥ Student Loans- $37,000, 6.8%, $270 minimum payment
♥ Credit Card 1- $5,000, 24%, $35 minimum payment
♥ Credit Card 2- $500, 18%, $15 minimum payment
♥ Car Loan- $15,000, 4.5%, $250 minimum payment
Between Jennifer’s two jobs, she has $500 a month extra she can put towards debt.
So which strategy should Jennifer use?
First, we need to understand how the debt strategies all work.
The debt snowball is probably one strategy you are most familiar with due to the popularity and love of financial guru Dave Ramsey. And for good reason too. You’ll find that as people call into Dave’s radio show and share their incredible debt free stories one thing become apparent– it works!
The concept of snowballing your debt isn’t new. But it is quite effective.
How it works
With the debt snowball method, you pay the minimum on all your debts and put all the extra money towards the smallest debt (balance) first. We are not even taking interest rates into consideration here.
So for Jennifer’s situation, she would be putting the extra $500 she has per month towards Credit Card 2 (the one with $500 balance). She will have CC2 paid off in one month.
Then when that debt is paid off she will then start to focus on the second smallest balance debt– Credit Card 1 ($5,000).
Debt Pay Off Order | Using The Snowball
♥ FOCUS 1: Credit Card 2- $500, 18%, $15 minimum payment
♥ FOCUS 2: Credit Card 1- $5,000, 24%, $35 minimum payment
♥ FOCUS 3: Car Loan- $15,000, 4.5%, $250 minimum payment
♥ FOCUS 4: Student Loans- $37,000, 6.8%, $270 minimum payment
But remember, we paid off CC2, so we now have that normal minimum monthly payment of $15 we can put towards CC1. Instead of paying $500 towards our next smallest debt, we are putting $515 per month towards CC1.
Once that debt is gone, we do the same thing again with the car loan, this time putting $550 ($500+$15+$35) towards the car. Rinse and repeat until all debt is gone.
Advantages of This Method
This method is killer for people who need to see progress (sooo, everyone?).????The reason it is so effective is because we are able to A) focus on one debt at a time and B) see progress fairly quickly giving us the “quick wins.”
Quick wins and seeing results fast means you are more likely to stick to your debt payoff plan.
We will call this is psychological approach.
The debt avalanche is perhaps one of the more logical and mathematically approached strategies. With the debt avalanche, you are still paying the minimum monthly payments on your debt, but instead of focusing on the smallest balance like we did with the snowball, we will instead focus on the highest interest rate debt.
Aka the debt that is costing you the most.
How it works
Once you have your debts listed out, we will then rank them from highest interest rate to lowest interest rate.
Here’s what Jennifer’s debt priority order will look like while using the avalanche.
Debt Pay Off Order | Using The Avalanche
♥ FOCUS 1:Credit Card 1- $5,000, 24%, $35 minimum payment
♥ FOCUS 2:Credit Card 2- $500, 18%, $15 minimum payment
♥ FOCUS 3:Student Loans- $37,000, 6.8%, $270 minimum payment
♥ FOCUS 4:Car Loan- $15,000, 4.5%, $250 minimum payment
It’s not drastically different until you see that the car loan comes last when paying it off because the interest rate is the lowest. But, going through this example, Jennifer will be paying the minimum on all debts except for CC1; she’ll be putting the extra $500 directly towards CC1. Once that debt is gone, she will then focus on CC2 now putting $535 (normal extra payment + $35 minimum from before) towards the second card.
Repeat the process. As you can see, just from a very simple math perspective, she will have CC1 paid off in 10 months.
Advantages of This Method
This method saves you the most money from an interest standpoint. Mathematically, it makes the most sense. If you are trying to save money and the thought of paying extra towards interest stresses you out, you might want to implement this method.
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This is a newer method to me, but one that can make a lot of sense in some scenarios. I first heard about a variation of this from a podcast interview and really liked it. For someone who is skimping by every month and barely making ends meet, cash flow matters and this approach, in a sense, helps you increase your income every month.
How it works
The Cash Flow Method takes into consideration your most expensive monthly payment. Whatever debt is taking away from your immediate cash flow every month, hurts the most from a financial perspective and should be paid off ASAP.
To follow this approach, you need rank all your debts by the minimum monthly payment each month and focus on the highest minimum payment. You are still paying only the minimum on all debts while you go through this process.
So for Jennifer to implement this, her order of debt payoffs would look like this:
Debt Pay Off Order | Using The Cash Flow Method
♥ FOCUS 1:Student Loans- $37,000, 6.8%, $270 minimum payment
♥ FOCUS 2:Car Loan- $15,000, 4.5%, $250 minimum payment
♥ FOCUS 3:Credit Card 1- $5,000, 24%, $35 minimum payment
♥ FOCUS 4:Credit Card 2- $500, 18%, $15 minimum payment
Jennifer would need to put the entire $500 towards the student loans every month. Again, paying the minimum on all other debts. Once she has paid off the student loan, approximately 6 years, she will have more $270 more each month that she could then put towards her car.
And to be fair, after 6 years of paying off debt, the car and CC2 will likely be gone.
Advantages
If cash flow is a concern for you or somewhat restricted, this method will help you feel like you are getting a raise every month. For some people, this method is awesome! From a cash flow standpoint alone, this is the best strategy.
I feel like this is the method 98% of people begin with. And it makes sense too. You are trying to do the right thing by putting extra towards all your debts. Hell, I’m pretty sure 5 years ago, I would have said this is a good way to go as well.
How it Works
Using the Equal Distribution method, you are paying a little extra towards each of the debt every month. If Grandma gives you $100 for your birthday, and you have 4 debts, you put $25 extra towards each debt, dust off your hands, high five yourself, and go back to business as usual.
Super common strategy.
For Jennifer’s situation, that $500 extra monthly payment would be divided up between her 4 debts. So there is no real focus order per-say. She would just be putting $125 towards each of her debts until they are all gone.
I mean… be honest. Was this the strategy you used for a long time too? (me = desperately pleading that I’m not alone.)
Using this approach CC2 will be paid off in 4 months.
Advantages
You are putting extra towards all debts and starting to decrease each of the balances simultaneously. You feel good about yourself because you are actively working towards your financial goals and seeing each of the balances go down.
Ah, yes. The million dollar question. Which strategy should you be using?
Well, the sh*tty but true answer is… it depends. It depends mostly on your personality, your preference, and your level of focus and commitment.
If you are the type of person who has a hell of a time sticking to a plan without seeing resutls quickly, the debt snowball is probably the right plan for you.
If you are the type of person who despises paying more interest than you should, the debt avalanche might be for you.
If cash flow is a big time struggle and it’s not going to take you a 5+ years to pay down the debt, the cash flow method might be a solid choice.
Frankly, everyone’s situation is so freakin’ different that saying one way is the right way and all others are bad is really not my forte.
But if I’m forced into a corner and must generalize, my preference is the debt snowball. I think most people need quick wins and the more results we can get more quickly, the more likely we are to stick to our debt payoff plan.
Ultimately, the debt payoff plan that works best, is the one you will stick with.
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