How much debt do you have?
What interest rates are you paying on that debt?
How long will it take you to pay off your debt at the current pace?
No idea? You’re not the only one – most people have a rough idea in their heads of how much money they owe, but few know the exact number, and even fewer know what they’re paying in interest rates.
If you’re like most Americans you carry some type of debt, whether it’s a car payment, student loans, credit card debt, or a mortgage. The harsh reality is that this method of payment is so deeply ingrained in our culture that we don’t usually think about it, and when we do we’re convinced that we’re handling it responsibly. While it’s easy to turn a blind eye, I encourage anyone looking to improve their financial position to take a good, hard look at what makes up your debt.
The first step to solving any problem is admitting you have one; if you’re making minimum payments every month or carrying balances that you don’t have a plan to pay off, it’s time to sit down and make “the list”. List out every debt you owe and what it’s for; car payments, student loans, every credit card, ALL OF IT. It can be scary putting it down on paper, but this is the first step to getting a handle on what you owe and how you’re going to tackle it.
In addition to the balances on each of these debts, make sure to list out the interest rate as well; this will come into play later when you’re deciding exactly how to tackle your debt. Knowing that you pay 16% on your credit card and only 4% on your car will factor into your decision on which one to pay down first, as will knowing that you only owe $5k on your credit card versus $12k on your car. You’ll also want to list out the monthly payment for each debt, as well as any other information – if you have any promotional rates or early repayment penalties, factor these in as well.
Once your list is complete, total everything up and take a look at what you have. More than you thought? This is the most important step because most people honestly have no idea how much debt they are in until they look at it, written down, all in one place. It can give you a reality check, a boost of confidence, or cause you to panic, but either way it’s necessary before you can decide how to tackle it.
Make a Plan
With this number in mind and a better idea of your interest rates, it’s time to make a plan. Think about what your goals are in the future, and how long you’d like to spend paying off this debt. Are you willing to take on a second job to knock it out quickly, or would you like to work it off slowly but surely over time? Everyone’s motivations for getting out of debt vary, so consider what motivates you, and how serious you are about tackling your debt within a given period of time.
Before deciding on a debt repayment method, be sure to factor in your other financial goals as well. For some people it makes sense to put all available funds towards paying off their debt, but I’m of the opinion that pausing on saving can hurt you in the long run. If you’re thinking about buying a house or having a family, consider what your debt repayment plan will mean for those goals as well; are you going to be putting those things off or fast-tracking them?
Knowing ahead of time what your long-term financial goals are is just as important as your list; some level of sacrifice is inherent to the process of getting out of debt, but be honest about what you are willing to do to reach your goals. Not everyone is ready to take on a second job, but maybe you’re willing to pass on a weekend trip to put that extra cash toward your debt.
Now that you have your other financial goals in mind, let’s go back to your list and take a look. While everyone’s list is going to look different, you’ll notice a couple of things; different types of debt carry different interest rates, and you’ll have some balances that are smaller than others. To determine which debts to tackle first, consider the two most popular approaches – the “snowball” method and the “avalanche” method.
The “Snowball” Method
One of the most popular methods of debt repayment is termed the “snowball” method and refers to paying off the smallest balance on your list first. By tackling the smallest loan with any extra funds you can put toward it, you’ll knock out the easiest debt first, and gain momentum by using that additional payment towards the next largest balance, and so on, hence the term “snowball”.
The beauty of this plan is that you’ll see fairly immediate results; if you have a small balance left on one of your credit cards or student loans, it can be extremely satisfying to see one debt wiped out completely – this gives you further motivation to roll on to the next balance and the next, with more available funds each time you pay off a loan in full.
The drawback to this plan is that it doesn’t necessarily save you the most money in the long run; if you’re paying off a small student loan with 5% interest and neglecting your larger credit card balances with higher interest rates, you’ll end up paying more money in the long run. The answer to this predicament is what’s referred to as the “avalanche” repayment method.
The “Avalanche” Method
While the “snowball” method tackles the smallest balance first, the “avalanche” method targets the highest interest rate first, which for most people is in credit cards. Once the highest interest rate loan is paid off, you move on to the next highest, and so on, regardless of the principal balance.
By paying off your highest interest loan first, you’re ensuring that you are paying the least amount of interest possible on your debt. If your debt repayment plan is likely to be spread out over a long period of time, this method can save you thousands of dollars in interest. The drawback here is that your highest interest rate debt may take you quite a bit longer to pay off than your smallest balance, so it can be a long and arduous process to see results, despite its overall benefits.
The other thing to keep in mind is that you don’t necessarily have to marry one method; you could start out by tackling your credit cards, and then move on to paying off the smallest balances after that. Flexibility within these options can keep your motivation up, but find what makes the most sense for you and go from there. Debt repayment is not a “one size fits all” solution, so make sure that your plan works for you.
Once you’ve decided on the repayment plan that works best for you, write it down and stick to it; whether you track your payments in a spreadsheet, on a white board or in your phone, make sure you’re celebrating those little milestones as you hit them. Rewarding yourself with a pat on the back (or a cold beer) is a great way to stay on track and remind yourself that even though paying down debt is not always fun, it’s 100% worth it in the long run.