How to Pay Off Debt

Debt 

The shackles to your life. The thing holding you back from living your best life. I wish I could say the key to happiness is paying off debt. Life is more complicated than that. But, I do know that paying off debt will help you sleep better at night. Interested in learning how to pay off debt? Read on!

To live without debt is to stop living paycheck to paycheck. To live without debt provides you the freedom to pursue your dreams.

This is why paying off debt is one of my top 10 money goals. So how do you do it? How do you get rid of this burden?

If you want the simplest of simple answers here it is:

1. Live below your means.
2. Spend less than you earn.
3. Pay off the debt.

Now that we got that out of the way, really how can you pay off debt? Everyone’s financial situation is different, everyone’s motivations are different. The way to pay off debt is unique to you but here are the top three strategies for paying off debt.

Snowball Approach

Using the debt snowball approach, you pay off debt from smallest to largest. 

Below are the steps to using the debt snowball approach:

1. Make a list of all your debts and rank them from the smallest balance to largest balance.
2. Make the minimum payment on all debts.
3. Put as much money into paying off your small debt as possible.
4. Once your smallest debt is paid, congratulations you are ready to advance to the next debt!

Debt Snowball Example

Let’s take this a step further and go through a hypothetical example of how the debt snowball method works.

Michael is a recent graduate from nursing school with some student loans, about $20,000.

After graduation, Michael moves to a new apartment but does not have any furniture so he purchases a bed, dresser, couch, and some kitchen supplies all on his credit cards, about $3,000. He split the $3,000 between two credit cards ($1,000 and $2,000).

Michael also needs a way to get to work. The public transit system is practically non-existent where he lives so to get to work he needs a car. Unfortunately, Michael does not have enough money to pay for a car in cash so he has to take out a loan, about $10,000.

Ok, Michael is ready for success! But is he? Burdened by debt before he even starts working, Michael feels overwhelmed. He makes it his number one priority to pay off all this debt as soon as possible. After reading about the various strategies, Michael decides the debt snowball approach is the best way to tackle his debt. He determines that he can pay an additional $300 towards his debt each month.

Debt Snowball List

Now that we are familiar with Michael’s financial situation, let’s see what his debt list looks like:

Debt	Amount	Interest Rate	Minimum Payment	Total Payment
Credit Card 1	$1,000	17.30%	$25	$325
Credit Card 2	$2,000	19.50%	$25	$25
Car Loan	$10,000	4.00%	$400	$400
Student Loans	$20,000	6.8%	$200	$200

Based on the information above, Michael will pay off Credit Card 1 in a little over 3 months ($325 * 3 months = $975).

Once he finishes paying off Credit Card 1, Michael moves on to paying off Credit Card 2 which he will pay off in a little over 6 months ($325 * 6 months = $1,950).

Michael will continue along this path until all of his debts are paid.

Who is the Debt Snowball Approach For?

Are you someone that is task oriented and feels good when they can check off the box or cross off an item on the to-do list? The snowball approach may be for you.  This will provide you with a feeling of “mission accomplished, one less thing to worry about”.

Advantages

The debt snowball approach has one major advantage – human psychology. Humans base all decisions on at least some degree of emotion. If you use this approach you will get quick wins which will build motivation. When you are motivated you are more likely to stick to your goals.

Disadvantages

The debt snowball approach is not the most mathematically efficient. It is highly likely you will end up paying more in interest when you use this method. 

Avalanche Approach

Using the debt avalanche approach, you will pay off debt from the highest interest rate first to the lowest interest rate until all your debts are paid off. 

Below are the steps to using the debt avalanche approach:

1. Make a list of all your debts with the debt that has the highest interest rate on top and the debt with the lowest interest rate on the bottom.
2. Make the minimum payment on all of the debts.
3. Put as much money as you can into pay off the debt with the highest interest rate.
4. Once you finish paying off the debt with the highest interest rate, congratulations, you are ready to move on to the debt with the next debt on the list!

Debt Avalanche Example

Now that we know conceptually how the debt avalanche approach works, lets add some additional context. In this example, we will use the same circumstances as the debt snowball approach described above. However, we will rearrange Michael’s debt list using the avalanche methodology.

Debt	Amount	Interest Rate	Minimum Payment	Total Payment
Credit Card 2	$2,000	19.50%	$25	$325
Credit Card 1	$1,000	17.30%	$25	$25
Student Loans	$20,000	6.80%	$200	$400
Car Loan	$10,000	4.00%	$400	$200

As you can see, the timing of when each debt will be paid has changed. Since Michael will be paying off Credit Card 2 first, it will take a little over 6 months for Michael to achieve his first victory ($325 * 6 months = $1,950). 

Once Credit Card 2 is paid, Michael will move on to Credit Card 1 which has a 17.30% interest rate and his second victory will be in a little over 3 months.

Michael will continue along this path until all of his debts are paid.

Advantages

Because you will be paying off debt starting with the highest interest rate first, the Debt Avalanche approach will save you the most amount of money.

Disadvantages

The Avalanche Approach is not designed to give you quick victories at the beginning of your debt pay-off journey. Therefore, you may end up losing momentum with the possibility of abandoning your goals. 

Who is the Debt Avalanche Approach For? 

Are you someone that gravitates towards accomplishing things in the most efficient way possible? The avalanche method may be for you. You will still have feelings of accomplishment, but in a different order.

The Third Approach

This is a combination of the Snowball Approach and the Avalanche Approach. There can be a lot of variability here and each person can and will handle this differently depending on their situation. But the result is the same, the debt is paid.

Takeaways

• The most important thing is to choose the method that you will stick to.
• If you have any questions let me know! I am happy to answer.
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