Two strategies to help tame your debts
With December coming to a close, we are all starting to think about our New Year’s Resolutions. And in addition to resolving to go the gym more often, there’s a good chance that your list of 2012 resolutions involves a financial goal.
If one of your goals is to pay down your debt, you’re not alone. According to a recent Statistics Canada report.
There are two basic strategies to tackling your debt, the debt avalanche: where you pay down the debt with the highest interest rate first and . the other is the debt snowball where you pay down the debt with the smallest balance first.
For example, if you owe $23,000 to five different creditors, you will first need to determine your interest rate for each debt, as well as your minimum monthly payment. Then, after you have satisfied your minimum debt repayment obligations, you must figure out how much extra you can put towards your debt each month.
For the example below, let’s assume there is an extra $200 in your budget to put towards debt repayment:
| Debt | Balance | Interest Rate |
| Visa | $6,000 | 21% |
| Line of Credit | $3,000 | 6% |
| Student Loan | $10,000 | 8% |
| Mastercard | $1,500 | 11% |
| Store credit card | $2,500 | 19% |
Debt Snowball
Using this method, you will list all of your debts in ascending order, from smallest to largest balance. Since your smallest debt would be your Mastercard, you will need to commit to paying the minimum payments on every debt, and apply the extra $200 each month towards the Mastercard.
Once that debt is paid in full, you will then roll the Mastercard minimum payment plus the extra $200 towards the next smallest debt, which would be the store credit card.
This method works because by paying the smaller debts first, you eliminate the number of creditors faster, giving you the motivation she needs to keep going.
Debt Avalanche
The debt avalanche is similar, except instead of paying off your smallest debt first, you repay the balance with the highest interest rate first.
Mathematically, this is the most effective way to repay debt because you end up paying less interest over the course of your repayment schedule.
So, in this example, you pay off the Visa bill first, because it has the highest interest rate. Then, once that is paid it off, you will take the minimum payment and the $200 extra payment and put it towards the debt with the next highest interest rate – which would be the store credit card.
Which method should you choose?
There is a lot of debate about which strategy is best. The debt snowball plays to emotions and a sense of victory when we achieve goals fairly quickly. However, avalanche is the rational and more mathematically correct method.
The debt snowball is best suited for people who are strongly influenced by emotion and prefer quick, tangible results. It is also an effective method if all of your debts are at relatively the same interest rate, since you won’t end up saving as much interest as someone who has varying interest rates.
I ended up using the debt avalanche. Even though I missed out on the emotional highs of getting rid of my creditors faster, I knew I was saving more money in the long run by eliminating my debt with the highest interest rate first.
Check out the website unbury.me to calculate whether the avalanche or snowball method will work best for your debt.
What debt repayment strategy do you use?