Paying Down Debt 101
Almost all of us will carry some form of debt in our lives. Eight out of Ten Americans have some form of debt, even though most of us would prefer not to carry any.
Most people run into debt issues when their loans carry high interest rates. Usually any interest rate higher than 10% is considered very high and anything above 5% considered high. Credit cards usually have a high interest rate but payday loans have the all time highest.
So what if you find yourself with a lot of high interest rate debt? How do you go about paying it off, especially if it seems like an impossible mountain to climb?
There are a few different theories on how you should prioritize paying off debt:
Avalanche: Pay down the debts with the largest interest rate first. This is my preferred method, although the Snowball method outlined below can have it’s advantages. The idea is that the loans with the largest interest rate will get bigger, faster, so it is best to get them taken care of first. The core idea behind the Avalanche method is that you will be paying less overall as you minimize the loans with the highest interest.
Snowball: Pay down the smallest balance size first. This method was designed by Dave Ramsey and can be popular with people who have many different balances. The idea behind this theory is that you will be motivated as you pay off your smaller balances and see the debts disappear from your reports. Also as you pay off balances, it limits the number minimum payments you have each month. However, you end up paying more overall as your largest interest rate loans may go for a long time with only the minimum balance paid off.
You have $1,500 after necessary expenses to put towards debt. Your debts are:
Loan1: $5,000 with minimum payment of $200/month, 5% interest
Loan2: $10,000 with minimum payment of $600/month, 15% interest
Minimum payments a month: $800. You have $700 a month after the minimum payments to put towards one of the loans. Paying towards Loan 1 would be the example of the Snowball method, while paying towards Loan2 would be the example of the Avalanche method. Paying towards Loan1 would save you $35 a year on interest, while paying on Loan2 would save you $105.
Despite the difference in interest amounts, there is not necessarily a right answer here. As I said above, I prefer the Avalanche method, but depending on your mindset and other factors, some people prefer the snowball method.
Note: Continue paying minimum payments on all balances! You can’t just decide to throw all your money at one, and neglect the minimum payments on the others.
High interest is usually considered anything above 5%. If the interest is low enough, you can consider just paying minimum payments and using your money elsewhere. I caution against this because “using your money elsewhere” often means investing in the market. While the market on average has exceeded 5% returns, there have been many years where it has done worse!