Debt is inevitable, and at some point in our lives, we’ve all found ourselves owing one debt or the other. It could be in the form of HECS debt, credit card debt, or mortgage payments. The size of the debt, along with the interest rate and repayment periods, can be overwhelming for anyone. However, thanks to the two most popular debt repayment methods – Debt Snowball and Debt Avalanche – getting out of debt has become less stressful.
If you’re new to the world of debt repayment, figuring out which method works best for you can be daunting. In this blog, we’ll explore both methods and see which is best suited for you.
Debt Snowball Method
The Debt Snowball method of debt repayment is all about the psychological satisfaction of incremental wins. It involves listing out your debts from smallest balances to largest, paying minimum payments on all debts except the smallest balance. Any amount that you can afford after paying the minimum amount should go towards the smallest balance. Once the smallest debt is paid off, the same amount is directed towards the second smallest until all debts are erased.
The Debt Snowball method provides a sense of progress, and as each debt is paid off, you become more motivated to tackle the rest. It helps that the small wins give a sense of quick accomplishment, which helps you set more realistic goals. However, it means that debts with a large interest rate will still hang around for longer. It is not the best option if you’re primarily seeking to minimise interest paid.
To better understand this method, let’s look at Sarah’s situation. Sarah employs the Debt Snowball method to tackle her three debts: Credit Card A ($500, 15% interest), Personal Loan B ($1,000, 10% interest), and HECS debt C ($5,000, 7% interest). Organising her debts from smallest to largest, Sarah pays the minimum amounts on Personal Loan B and HECS debt C while allocating any extra funds to Credit Card A. After successfully paying off Credit Card A, she redirects the combined payment towards Personal Loan B. This sequential approach allows her to celebrate small victories with each debt cleared, fostering motivation and a sense of accomplishment. The method’s psychological benefits help Sarah persist in her debt repayment journey, addressing each obligation systematically until she eliminates all outstanding balances.
Debt Avalanche Method
The Debt Avalanche method, on the other hand, prioritises the debts with the highest interest rates. Here, list all debts from the highest interest rate to the lowest and begin by paying off the one with the highest interest rate, while paying minimums on the remaining balance. Once the debt with the highest interest rate is paid off, the same process is repeated for the second-highest interest rate, and so on.
The Debt Avalanche method is suitable for those who want to save money on interest rates. It ensures that you pay the least possible amount on your debts, which in turn means that you’ll clear your debts faster. It means it doesn’t matter the size of the balance or how long it takes to pay it, the priority is on the interest rate. However, it might take a while to get the sense of accomplishment that comes with paying off a debt entirely, especially if the debt with the largest interest rate is a massive debt.
Let’s consider James, who has three outstanding debts with varying interest rates:
- Credit Card X: $1,500 balance with a 20% interest rate.
- Personal Loan Y: $3,000 balance with a 15% interest rate.
- HECS debt Z: $8,000 balance with a 10% interest rate.
Following the Debt Avalanche method, James arranges his debts from the highest to the lowest interest rate:
1. Credit Card X: $1,500 (highest interest rate)
2. Personal Loan Y: $3,000
3. HECS debt Z: $8,000 (lowest interest rate)
James focuses on paying off Credit Card X aggressively, allocating extra funds towards it while making minimum payments on Personal Loan Y and HECS debt Z. Once Credit Card X is paid off, he directs the same focused approach towards Personal Loan Y, and finally, he addresses the remaining HECS debt Z. In employing the Debt Avalanche method, James strategically targets his debts based on their interest rates, starting with the highest. By prioritising the 20% interest rate on Credit Card X, he accelerates the repayment process for this debt, subsequently moving on to the next highest interest rate and continuing until all debts are settled. This method proves effective in minimising overall interest payments, allowing James to clear his debts more efficiently. While the approach may delay the immediate sense of accomplishment associated with paying off an entire debt, the financial benefits make it a prudent choice for those focused on interest rate optimisation in the long run.
Which Method is the Best for You?
The best answer to which method is the most suitable for you depends on your debt situation and goals. If quick wins are what you desire, consider the Debt Snowball method. It shows fast progress, the debts are generally paid off in full, and this can increase your confidence level. It may also be that you have many small debts with balances that are easier to manage. The Debt Snowball method may be the best option for you.
On the other hand, if you’re more drawn to aggressively ending your debts and coming out debt-free, consider the Debt Avalanche method. It focuses on minimising interest and accelerating payment to the irritant of an instant sense of progress. The method may help you stick to paying off your debts in a more structured and organised way, but it may take longer to achieve quick wins.
In conclusion, whichever way you choose to go, tracking your progress is crucial. You should also be mindful of any necessary budget cuts that can be made to accelerate your debt payment journey. It’s essential to remember that the debt repayment journey is a marathon and not a sprint. Don’t give up if one method doesn’t work for you. Keep trying, keep adjusting your budget, and in no time, you’ll be debt-free.
If you would like to start building a secure financial future, please click here to organise a complimentary meeting with an EPG Wealth adviser.