If you want to stir up a hornet's nest among personal-finance bloggers, declare that the debt snowball is far superior to the debt avalanche, or vice versa.
Most people won't understand what the heck you're talking about, but passionate adherents of either debt payoff method will spend hours honing their arguments and rebuttals.
Both approaches (which I'll explain in a minute) have their advantages and drawbacks, but a fistfight over methods is the last thing you need when you're sinking deeper in debt. You just want to know the best strategy for clawing your way out.
So here's the short version: Any method can work if you free up enough income and apply it diligently to your debts. But if you want to craft the smartest payoff plan possible, you shouldn't marry any single approach but instead create a plan that reflects your individual situation and types of debt.
I have some ideas about how best to do that, but let's define some terms before we go further:
- Using the debt snowball approach, you order your debts by size and pay off the smallest first, on the theory that quick wins will keep you motivated. You throw as much money as possible at your chosen debt while paying the minimums on the rest. When the targeted debt is gone, you apply the same payment plus the minimum to the next debt, and so on. The amount you apply to your targeted debt grows as you pay off each bill, and you pack together those little victories to make a big dent in what you owe. This method is touted by personal-finance guru Dave Ramsey and his many enthusiastic followers.
- With the debt avalanche method, you pay off your debts by interest rate, tackling the highest rates first. The term was popularized by blogger Flexo at Consumerism Commentary, although the method has been applied for years by financial planners and others. The avalanche is the mathematically superior approach because you will pay less interest and can get out of debt quicker.
- A third method, the debt snowflake, can supplement the other strategies. When you snowflake, you look for little ways to trim your expenses. Brown-bagging it today? If you were "snowflaking," you would apply the $10 you'd saved on lunch directly to your debts, either the same day or at the end of the week (hopefully combined with other little snowflakes of savings).
- Finally, because we're getting all chilly, I'll coin a new phrase: debt calving. A glacier calves when a big chunk of ice shears off its face, typically landing in the water with a big splash. Debt calving is when you get a big windfall and throw chunks of it at your debts.
Before you start freezing out your debts, though, you need to take a closer look at what you owe and create a plan. Here's what you do:
List all of your debts
You need an inventory of everything you owe. Go through your bills and pull copies of your credit reports (get free access annually at AnnualCreditReport.com) to make sure you don't miss any accounts.Don't forget to include:
- Credit cards.
- Store cards.
- Gas cards.
- Personal loans.
- Retirement plan loans.
- Life insurance loans.
- Federal student loans.
- Private student loans.
- Mortgages.
- Home equity loans or lines of credit.
- Business loans.
- Auto loans.
- Boat loans.
- Other vehicle loans.
- Medical debt.
- Debt consolidation loans.
- Collection accounts.
- Payday loans.
- Pawnshop loans.
- Title loans.
- Overdraft balances.
For each debt, you'll need to note whom you owe, how much you owe, the current interest rate and the minimum payment.
You can typically find the interest rate of a loan on your monthly statement or by calling your lender to ask. Calculating interest rates for payday advances and overdraft balances is tougher, but you can figure your annualized interest rate is in the triple digits, so these should be at the top of your payoff list.
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Negotiate for lower rates
Lower interest rates will help you get out of debt faster, so you want to check the possibilities for getting better rates on each of your debts. Some ideas:- Consider balance transfer offers, personal loans or peer-to-peer lending. You might be able to get a better credit card interest rate using a balance transfer offer, although you have to do the math. Fees for these offers usually increase the debt you're transferring by 3% to 4%, so the interest rate break needs to be big enough and last long enough to offset the fee.
- You can find offers at CardRatings.com, Bankrate.com and CreditCards.com. Also check into personal loans from your bank or credit union or a loan from a peer-to-peer site such as Prosper or Lending Club. The rates on these loans are typically fixed, unlike credit cards rates, which can soar to 30% or more.
- Consolidate federal student loans and choose the longest possible repayment term. Consolidation will fix your rate if it's variable and may allow you more than the usual 10 years to pay off your balance. The more debt you have, the longer the repayment term you can choose. (See "Consolidate your student loans now.") Stretching your loans over 15, 20 or 30 years will lower your monthly payment for this good debt so you can throw more money at your toxic debts. Once higher-priority debts are paid, you can speed up your student loan payments. If your job qualifies, you may also be eligible for student loan forgiveness after 10 years.
- Use home equity or retirement plan loans with care. You may be able to lower your interest rates by using these loans to pay off other debts, but you're also putting your wealth at considerable risk. For more, read "The 3 worst money moves you can make."
Categorize your debts
Divide your debts into "good," "neutral" and "toxic" piles. There are those who believe there's no such thing as good debt, but financial planners know that certain obligations can help you get ahead.
Video: Embracing a budgetA reasonable amount of mortgage debt, for example, will improve your net worth over time as the home gains value (it will eventually, you know). Federal student loans and business loans, in moderation, can help you boost your lifetime income.
These loans have other things in common: The interest rates are often low and typically deductible, further reducing the costs of carrying this debt.
Continued: Prioritize your debts
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