- August 20, 2018
- Posted by: moat_admin
- Category: knowledge center
Today, we want to discuss how you can choose a debt repayment strategy to make sure you stay on track and reach debt freedom as soon as you can. These methods can help you power through and repay every last balance.
The Debt Snowball
The debt snowball is a debt repayment strategy popularized by financial guru Dave Ramsey. This method asks you to take stock of all your debts — loans, credit cards, mortgages, and other lines of credit with balances — and list them in order of smallest balance to biggest.
That’s the only factor you need to take into account. So, for example, if you have three student loans and owe Rs. 50,000, Rs. 1,00,000, and Rs. 15,00000 respectively, that’s exactly the order you list them out in. And that’s the order you’d work to pay them off in, too.
The debt snowball has you put as much money as you can toward your debt with the lowest balance first, while still maintaining minimum payments on your other balances. Once you repay that first debt, you take the amount of money you were applying toward it, and combine it with the minimum payment you were making on the loan with the second-lowest balance.
Your payment on this second-lowest balance loan “snowballs,” because the payment is the combination of what you paid toward the first loan and the minimum payment you were already paying on the second.
You’ll continue to snowball your payments and knock out your debts one by one, until you’re debt free.
The Debt Avalanche
The debt avalanche is another system for repaying your debt. With this strategy, you again take stock of all your debts and list them out — but this time, you’ll order them by interest rate.
With the debt avalanche, you’ll list them out in order from highest interest rate to lowest (regardless of balance). Then you’ll work to repay the balances in that order, taking out the loan with the highest interest rate first, then the second-highest, and so on.
The only difference from the debt snowball is the order in which you repay your loans. The biggest advantage to the avalanche is, from a mathematical standpoint, you come out ahead because you’re getting rid of your most costly loans first. Because you’re knocking out loans by interest rate, you’ll gradually pay less in interest over your repayment period.
Choosing a Debt Repayment Strategy
There’s no “wrong” way to knock out balances and become debt-free. But there’s probably one strategy that works best for you over other options. So how do you choose the ideal system for your personal situation?
Start by understanding your own personality. The right strategy is likely the one that’s a good fit for you and the way you think. It’s not necessarily about the details of your debt.
The debt snowball does a good job of taking the emotional and behavioral part of personal finances into account. For many of us, money is about more than just the numbers — it’s how we feel and think about it.
The snowball can keep you on track because it gets you to a “win” quickly. Since you’re paying off the lowest balance first, this repayment strategy will likely knock out your first loan faster than other methods of paying down your debt.
This can be the difference between sticking to the hard work it takes to become debt free, and getting frustrated and overwhelmed by the process.
The debt avalanche is, mathematically speaking, usually better than the snowball. That’s because you focus on getting rid of the debt with the highest interest rate first, regardless of balance. This should save you money over the long-term because you’re lessening how much you’re paying in interest.
But if your highest-interest loan also comes with a bigger balance than your other loans, it’s going to take you longer to repay that debt than if you focused on knocking out loans with balances in order from smallest to largest. For some, it’s emotionally tough to have that first milestone be further down the road.
And that’s okay — it feels good to get rid of loans or balances on your lines of credit!
It all depends on what motivates you. If paying off your first loan ASAP will keep you going and prevent you from feeling discouraged or hopeless, choose the debt snowball. If you want to put an end to interest rates eating up your discretionary income, choose the debt avalanche.
What About Debt Consolidation?
Debt consolidation is another strategy that may be helpful if you’re struggling to keep track of multiple loans and their payments, due dates, and other information. Consolidation can also help those who have high interest rate loans but good credit scores.
When you consolidate, you start by taking out a single loan for the total amount of the debt you want to repay. You take the borrowed money from the new loan and repay all the individual loans with balances you already had. Then, you work to repay the single, new loan.
This is a good option if you’re feeling overwhelmed because it simplifies your financial situation. Instead of having multiple loans to keep track of, consolidating leaves you with a single loan — with a single interest rate, monthly payment, and due date.
It’s also worth looking into if your current loans carry high interest rates that cost you money. There’s no guarantee, but you can shop around with different lenders to possibly consolidate existing loans for a lower interest rate. This not only simplifies your debts — since, again, there will only be one balance to keep up with — but it could also save you money if you can get a lower interest rate.
Just make sure you take all the fees into account. A new loan may come with a lower interest rate, but the loan origination fees may mean it’s a wash when it comes to saving money. Everyone’s situation is different, so do the math before making any decisions or you can log on to Moat.co.in to get “debt knocking off plan” for you.
Source of information: Mint.com