Debt can be a helpful tool, helping us pay for things we need, like a home, a car or a college education. But it can also be a significant burden if we let it get out of hand.
Debt is a fact of life for most Americans. The average U.S. household owed $163,268 in debt as of June 2022, including an average of $219,206 owed on mortgages, $59,133 on student loans and $28,882 on auto loans.
During the COVID pandemic, Americans managed to reduce their credit card balances carried from one month to the next by an average of almost 14%, to $6,006. Still, credit card interest rates remain among the highest of any form of debt most of us face, averaging 16.2% as of February 2022. The average U.S. household pays $1,029 a year in credit card interest charges.
It’s vital to your financial welfare to keep debt under control. But paying down debt can be daunting. And when it comes to deciding how to pay down debt, you have choices to make on the best strategy.
That’s where terms like debt-snowball method and debt-avalanche method come into play. Either can be an effective strategy for tackling your debts. Each has its advantages and disadvantages. Let’s take a look.
What is the debt-snowball method?
The idea is to focus on paying off your smallest debt first, then the next smallest, and so on. Meanwhile, you make the minimum monthly payment required on all your debts.
Once you eliminate that first debt, you free up extra money that you can apply to your next debt. That’s why it’s called the debt snowball method — because your available cash to pay down debt grows like a snowball rolling down a snowy slope.
How the snowball method works
Investopedia offers this example. Say you look at your finances and decide you can consistently spare $1,000 a month to apply toward all your debts. And let’s say your debts include a $2,000 balance on your auto loan with a $300 monthly minimum payment, a $5,000 credit card balance with a monthly minimum of $50, and a $30,000 balance on a student loan with a $400 monthly minimum. That makes the auto loan your smallest debt.
So, you would pay the required monthly minimums on all those debts — a total of $750 — and
then pay an extra $250 a month toward the auto loan until it’s paid off. Along with the $300 minimum, you’re paying $550 a month toward your auto loan, enough to pay it off in a few months. Once the auto loan is taken care of, your combined minimum monthly payments will be down to $450, leaving you $550 extra out of your $1,000 monthly payoff budget to apply toward your next-biggest debt, the credit card. Once that’s paid off, all $1,000 of your monthly payoff budget can go to the student loan until you’re debt-free.
What is the debt-avalanche method?
This approach also focuses on paying off one debt at a time. Under the avalanche method, instead of starting with the smallest debt balance, you start with your highest-interest debt, regardless of how much you owe.
For most people, that would mean starting with high-interest credit cards, then moving on to loans ranked by interest rate (highest to lowest).
How the avalanche method works
It works much the same way as the snowball method. You decide how much money you can spend each month paying down debts, pay your required minimum monthly payments on all debts, and apply whatever is left over to your highest-interest debt until it’s paid off. Then you tackle your second-highest interest debt and so on.
Snowball vs. avalanche
The argument for the snowball method is that you’ll quickly get a psychological lift from paying off a small debt relatively quickly, inspiring you to keep going. You may also eliminate one of your debts sooner than with the avalanche system.
On the other hand, advocates for the avalanche method argue you’ll pay more in the long run if you don’t tackle your high-interest debt first because otherwise it will continue to compound and grow. By trimming interest faster, you might pay off all your debts a little sooner.
In some cases, you can use both methods simultaneously, if your smallest debt happens to be a high-interest credit card balance, for example.
But first, consider this
Before embarking on either payoff approach, make sure you have enough money to cover emergencies and your regular living expenses, like rent, groceries and utilities.
You’ll need to be disciplined to make these plans work. In setting a monthly amount to apply to your debts, make sure it’s a figure you can live with monthly, year after year. Some online debt-repayment calculators can help you develop a debt plan.
However you tackle your debt, don’t add expensive new debt to pay off old debt. For example, avoid drawing cash advances off your credit cards to apply to current debts. Credit card companies often charge a higher interest rate for cash advances than for purchases, plus a fee. That said, you may be able to refinance high-interest credit cards with a lower-interest personal loan or line of credit, depending on your credit rating.
If your debt is overwhelming, help is available. The Federal Trade Commission offers advice here on coping with overwhelming debt, including ways to find a reputable debt-relief service.
Finances FYI is presented by 1st Security Bank.
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