Debt can be an unavoidable part of life, but it’s not always a negative thing. Easy access to credit and carrying a manageable amount of debt is usually a good thing for a consumer. For instance, going into debt is the only way most of us can afford to own a house. The important part is making sure you’re able to pay off debt on your own terms.
Debt management is critical to your overall financial stability and well-being. And if you have no idea whether your debt situation is getting out of control – or how to figure that out – there’s a simple place to start: calculating your debt-to-income ratio (DTI).
How does DTI work? Well, let’s do a little math. If your monthly debt payments are $5,000 and your monthly income is $7,500, your DTI is 66%. Most financial advisors recommend keeping your DTI at around 30 percent.
Check out Best Egg Financial Health and use our free DTI calculator to get started.
A high DTI can also be detrimental to your credit score, which may make it harder to qualify for a mortgage or get the best interest rates when searching for a new credit line. If it feels like your monthly payments for credit cards and loans are getting to be a bit much, it might be time to take a different approach to your debt.
How to get a handle on your finances
To pay off debt, you’ve got to know the details: How much do you owe? Who do you owe it to? What are the interest rates for each? What are the minimum payments and when are they due?
It’s easy to get overwhelmed at the beginning of tackling your debt mountain. “Where do I start? How do I get my debt under control – or even become debt-free?”
Don’t worry. It might not be the easiest task, but with a little know-how, you can absolutely figure it out. Let’s get to it.
First, look at your monthly budget and determine how much extra money you can devote to debt repayment. At first glance, you might feel like there’s no wiggle room in your spending. But look again – usually, there are some sacrifices we can make to free up even a little bit of cash.
How often do you eat out? How many streaming services do you subscribe to? Can you live without cable? Can you reduce grocery expenses? Can you trade an expensive vacation for something closer to home? And, really, do you need a car wash every two weeks?
If you’re short on motivation to tighten up your budget, try adding up how much you are paying on interest alone – not even the debt itself. It’s a number that might surprise you. That will be money in your pocket once you find a way to start paying down your debts in a big way.
And if you don’t have a savings plan built into your budget, you should definitely start – a savings cushion can help you to avoid using credit in unexpected situations, such as a vet bill or car repair. That means less debt to pay down. The most effective way is to divert some of your monthly income into a savings account so you aren’t tempted to spend it, so make sure to include that in your budget.
Pick a debt-repayment strategy, and if you have a spouse or partner, make sure it’s a strategy you both agree on. In this article, we’ll describe two popular debt repayment methods:
- The Snowball Method
- The Avalanche Method
Each has its pros and cons, and we’ll explore each in detail.
What is the Debt Snowball Method?
Think of a snowball rolling down a hill. It starts small and grows as it gains momentum. It goes faster and faster, getting bigger and bigger, until you’ve got a boulder-sized snowball coming right at you.
The Debt Snowball Method is just like that: you start off with paying the small debts first and use that momentum to tackle the big ones.
Start by prioritizing your debts by size, smallest to biggest. By this point, you should have figured out your debt repayment budget. Schedule minimum payments for your heftier debts and focus the remainder on paying off the smallest debts.
Before you know it, you’ll be making the last payment on the smallest debt. You won’t believe how good paying off that first one will feel. So good, you’ll want to do it over and over again.
Now, move on to the next smallest debt. You may be tempted to reduce the size of your debt repayment budget, but don’t! Maintain the minimum payments on all your other debts and focus that energy on the next debt in line.
Keep rolling on this road until all the debts are retired. It could be sooner than you think.
Pros and Cons of the Snowball Method:
- Pro: Getting rid of those smaller debts gives you psychological victories that help you keep up the momentum.
- Pro: As you reduce the number of accounts with outstanding balances, you’re reducing your credit utilization ratio, which is a measure of the amount of credit you have available compared to the amount you are using. That could improve your credit score.
- Con: In the long run, the Debt Snowball could cost you more in interest than the Debt Avalanche because you’re prioritizing your debts by size, and not by interest rate. If, for example, your largest debt is a credit card balance with an APR of 21.99 percent, that will be the one you’ll be paying off last. You will pay (steep!) interest on that credit card debt longer than on all the others.
What Is the Debt Avalanche Method?
Now, think of an avalanche. A big chunk of snow and ice rumbles down a mountain all at once! That can be pretty scary when coupled with the concept of debt, but in this case, it’s a good thing.
The Debt Avalanche Method basically moves in the opposite direction of the Snowball method. You attack the chunk of debt with the biggest interest rate, regardless of how large or small that debt is. The goal is to reduce the amount of high-interest debt first, thereby reducing the amount of interest you pay overall.
First step? Prioritize your debts by interest rate, highest to lowest. Credit cards often have the highest interest rates, while student loans and car loans (which can be as low as zero percent) are often the lowest.
The process is the same: Make your minimum payments on all debts, and throw the rest of your debt repayment budget at the highest rate debt. Repeat as needed until all debts are retired.
Pros and Cons of the Avalanche Method
- Pro: with the Debt Avalanche method, you pay less in total interest because you’re reducing the opportunities for that interest to grow.
- Con: If the highest-interest debt is a big one, it may take several years to pay off. That means you’ll still have all your smaller lingering debts as well, collecting interest. And with such a long-term goal, there are no small victories to celebrate. That can be discouraging.
What Is the Best Debt Payoff Method?
Snowball or Avalanche? Let’s use a fictional couple, Liz and Fitz, to explore that question.
Liz and Fitz have the following debts totaling $43,700:
- Student loans: $17,500 at 5 percent interest, minimum payment $150 month
- Credit card 1: $4,100 at 15.99 percent interest, minimum payment $80 a month
- Credit card 2: $9,300 at 16.99 percent interest, minimum payment $260 a month
- Car loan: $12,200 at 2 percent interest, minimum payment $325 a month
- Store credit card: $600 at 21.99 percent interest, minimum payment $23 a month
They determine they can pay $1,500 a month toward their debts. Their minimum payments add up to $838 a month, leaving them an additional $662 a month to put toward extra payments.
If Liz and Fitz use the Snowball Method, they will be debt-free in 2024, and will have paid $3,771 in total interest. This assumes (and it’s a big assumption) they avoid taking on any additional debt during the repayment period. That savings cushion we discussed earlier will help them handle unexpected expenses.
If they choose the Avalanche Method, prioritizing the highest-interest debts, they will still be debt-free in 2024, having paid only $3,590 in interest. It’s a relatively small reduction in interest for the same result.
In contrast, if they continue to make only the minimum monthly payments on all of their debts, they won’t be debt-free until 2035, and they will have paid $13,756 in interest! That’s a lot of money.
Your non-mortgage debts could line up in such a way that you can do snowball and avalanche at the same time. For example, Liz and Fitz’s smallest debt also carries the highest interest rate. But even if that’s not the case, one of these strategies could help you have a brighter financial future.
Debt be gone!
Both plans have their different strategies, but the end goal is the same. Each requires coming up with a budget, listing debt, and focusing on one account to pay off at a time. The difference in the total amount of time it takes to pay off all the debt and the total amount of interest might be insignificant — as long as the plan you choose motivates you.
To help you decide which route to choose, you can use an online debt-repayment calculator. If you find it will take you more than five years to become debt-free, you may need to look at other strategies such as debt consolidation or refinancing your debt. Check out Best Egg’s Resource Center to learn more about those options.