by Damon Carr, For New Pittsburgh Courier
How should I prioritize paying off my debt? Should I prioritize paying off the lowest balance first or paying off the one with the highest interest rate?
~ Josuha
Damon says:
There are three methods that are taught in regards to best practices to eradicate debt. They are: Debt Avalanche, Debt Snowball, Debt Domino.
The Debt Avalanche prioritizes debt based on highest to lowest interest rates. You write down each debt and its corresponding interest rate. The debt with the highest interest rate will be priority #1. Pay minimum payment on all other debt. The debt with the highest interest rate gets the minimum payment plus any extra amount that you can apply towards it. Once this debt is paid off, you focus on the next debt that has the highest interest rate. Continue to consistently apply this method until all debts are paid. The primary benefit here is by attacking the highest interest rate, you in effect reduce the overall interest you pay to your creditors.
The Debt Snowball prioritizes based on lowest to highest balance. You write down each debt and its corresponding balance. The debt with the lowest balance will be priority #1. Pay minimum payment on all other debt. The debt with the lowest balance gets the minimum payment plus any extra amount that you can apply towards it. Once this debt is paid off, you focus on the next debt that has the lowest balance. Continue to consistently apply this method until all debts are paid. The primary benefit here being by attacking the lowest balance, you experience quick wins and are more likely to stay the course as you see various debts disappear.
The Debt Domino prioritizes debt based on the debt with the least amount of time to pay off. This is my preferred method. This method is harder to explain because it requires an additional step. You write down each debt and both its corresponding balance and minimum payment. The math to prioritize using the Debt Domino works this way. Take the balance and divide it by the minimum monthly payment. For example you have a debt with a $5,000 balance and a minimum payment of $200 per month. You take $5,000 / $200 = 25. Using rough and dirty, back of a napkin math, by making the minimum payment on this debt, it will take you approximately 25 months or 2 years and 1 month to pay off in full. You apply this same calculation to all outstanding debt. The debt with the least amount of time remaining to pay in full will be priority #1. Pay minimum payment on all other debt. The debt with the lowest term to repay gets the minimum payment plus any extra amount that you can apply towards it. Once this debt is paid off, you focus on the next debt that has the lowest term. Continue to consistently apply this method until all debts are paid. The reason this method is effective is because the shorter the term, or the less time you have remaining to repay a debt, the larger the portion of your minimum payment is applied towards the principal. By applying an extra payment on top of the minimum payment, you’re able to drastically reduce the remaining term left on the debt.
Here’s the telling part. The key to successfully and quickly paying off your debt isn’t which method you use—be it Debt Avalanche, Debt Snowball or Debt Domino. The key is choosing a method, sticking to it and continuing to consistently work the method until all debt is paid.
Here’s why. I ran multiple scenarios on all three methods on multiple clients. Regardless of which method a person chooses, the length of time to pay off all debt varies by 2 to 6 months. In other words, no method is that much better than the other one. I repeat, the key is to get on board with one of them and consistently do it.
In many cases you’ll find that regardless of the method you choose, you’ll more than likely be attacking most of the debt in the same order.
Debt Avalanche is based on the highest to lowest interest rate. Highest to lowest interest tends to go in this order: Credit cards, personal loans, car loans, student loans, mortgages.
Debt Snowball is based on the lowest to highest balance. The lowest to highest balance tends to go in this order: credit cards, personal loans, car loans, student loans, mortgages. Same difference!?
By employing the extra math step in the Debt Domino, it’s taking interest rate into account but it’s also recognizing debts that you’ve been paying on for a long period of time. Hence the reason why it has a shorter term and more of the payment is applied to principal reduction.
Here’s a couple things to avoid as you work to payoff debt:
Do not do a balance transfer to ZERO interest credit cards. The ZERO interest rate is good for 6-16 months. After which, the interest rate goes back to its double-digit interest rate level. But Damon, I’ll pay it off in the 6-16 months. I’ve heard that before. I’ve said that before. The truth of the matter is most people don’t pay it off during the time period where the interest rate was 0 percent. In the end, they have a balance on this new card where the balance was transferred to. With the increased available balance on the old card that the balance was transferred from, people go willy-nilly spending on the credit card again. Now they have double the credit card mess to clean up.
If you’re going to consolidate, get a personal loan with a fixed interest rate with a term no greater than three years. Under a personal loan, you can’t borrow the money after you paid it back.
The Number 1 rule to getting out of debt is this: STOP BORROWING MONEY!! To continue to borrow while you’re paying off debt is akin to trying to fill up a bucket with water but the bucket has holes. It’s not going to work.
(Damon Carr, Money Coach can be reached 412-216-1013 or visit his website at www.damonmoneycoach.com)