Debt: Types of debt, How to use it and pay it off
Updated: Jun 22, 2020
Many people think that debt is evil. When you think of the millions of people who have declared bankruptcy and have spent the majority of their life living in debt, you can understand why people believe that debt is evil.
With one notable exception (more on that in a minute), debt is not evil. In fact, debt is not even bad. The problem is how most people use debt.
If you are struggling with debt, you are going to want to read this article in its entirety to learn the difference between good debt and bad debt, how people fall into debt, how to get out of debt, and the two scenarios where you should not pay off your credit card.
What is debt?
Debt is simply a financial tool that allows you to buy something if you don’t have enough money available to make the purchase using cash.
Debt is no more “evil” or “bad” than any other tool like a hammer. It is the misuse of this financial tool that causes pain and suffering to so many people.
If you use debt in the right way, it has the potential to increase your wealth and improve your life.
If you use debt in the wrong way, it will take you down the path to financial misery.
Let me be clear on what I mean when I say, “if you use debt the right or wrong way.” Four factors will determine if you are using debt properly.
The type of debt you are using.
The purpose of which you are using that debt.
How much debt you take on.
The interest rate and repayment terms of that debt.
Those four factors are what make the difference between good debt and bad debt.
Good debt vs. bad debt
To further clarify the difference between good debt and bad debt, let’s review the eight types of debt and rank them from worst to best.
1. Payday loans
Remember when I said debt is not “evil?” I might need to amend that statement because there is one type of debt that might actually be evil, and that is payday loans.
What are payday loans? Payday loans are a bridge loan to provide cash for people who have run out of money and need to pay bills before their next paycheck.
That sounds pretty harmless and, in fact, like it provides real value to the borrower. You might be wondering why payday loans are bad? The issue with payday loans is that they have the potential to hook borrowers into dependency and keep them coming back every month.
Think of it this way; if you can’t afford to pay your bills this month, there is a decent chance you won’t be able to pay your bills next month. This is especially true when you just added a new loan that needs to be paid off on top of your regular expenses.
Here are two stunning statistics about payday loans.
80% of payday loan borrowers are repeat customers.
According to a report from the Centre for responsible investing, the typical Average Percent Rate (APR) on a payday loan ranges from 391% to 443%.
Payday loans can trap you in a vicious cycle of dependency on ultra high-interest debt. For that reason, payday loans are the worst type of debt and should be avoided.
2. Credit cards
In contrast to payday loans, credit cards are not “bad.” They are, however, the most mismanaged and abused type of debt in the world today. The average American owes $5,700 on their credit card. If that does not sound like a lot of money, consider the fact that the average APR for credit cards was over 16% in May 2020. It’s not uncommon for credit card rates to be as high as 20% or even 30%.
You can’t find an investment that can guarantee you a 16%-30% annual rate of return. It does not exist. If you carry a credit card balance, credit card companies are making more money off you than Warren Buffett or any investment manager could ever make in the stock market.
How to manage credit cards
Managing credit cards is simple. There is one golden rule to successfully managing credit cards; always pay off your outstanding balance immediately after making a purchase. If you do that, you will avoid all the pitfalls of credit cards and begin building up your credit score.
This means you only use your credit card to buy something that you could have purchased using cash. To make this easier, most credit card companies offer a grace period where no interest is charged. Typically this grace period is three weeks. If you pay your credit card balance within the grace period, you won’t be charged interest.
Credit card cash advances
It’s important to know that this three week grace period for credit cards does not apply to cash advances made on your card. A credit card cash advance is when you use your credit card at an ATM to withdraw cash.
There are three crucial facts you need to know about using your credit card to make a cash advance.
Interest begins accruing immediately. There is no grace period; you start racking up interest the second the ATM spits the money out.
Cash advance interest rates are higher than standard credit card rates. The average interest rate on cash advances is around 24%.
You pay an additional administration fee. To rub salt in the wound, credit card companies often charge an administration fee in addition to the interest you pay on cash advance. These fees might be a flat rate like $5 or $10, or it could be a percentage of the amount of the cash advance you are making.
How to read a credit card statement
If you have never reviewed your monthly credit card statement, you should because it contains a lot of useful information.
Let’s review a sample credit card statement from an old credit card I had several years ago. Every month your credit card company should send you a statement that looks something like this.
Your monthly statement contains a lot of information and can feel intimidating. It’s not as complicated as it looks, and specifically, we will be looking for the following information on a credit card statement.
Name of the financial institution which gave me the credit card. If you have multiple credit cards with the same bank you could sort them by the type of card, for example, this card is what’s called an “Aventura Visa Infinite” card.
You’re also going to need to know the current balance on the card.
The interest rate you pay on any outstanding balance.
The minimum payment required.
The due date of that minimum payment.
Consequences of missing that minimum payment due date.
If we zoom in a little closer, we can easily find that information.
The first thing you’ll likely notice is what’s usually called a “summary of account activity” or as my bank called it “your account at a glance.”
Let’s go through this line by line to understand what we are reading.
Previous balance: Balance on the credit card last month.
Payments: Total amount of payments you have made since the last statement
Other credits: Total of any other transactions that reduce your credit card balance, for example, returning an item and having it refunded on your card.
Total credits= Payments + Other credits.
Purchases: Total cost of all the things you purchased with your credit card since the last statement.
Cash advances: Total of any cash you have borrowed from your credit card since the last statement.
Interest: Any interest you have been charged from carrying a balance on your credit card.
Fees: Any other fees charged to your account.
Total charges= Purchases + Cash advances + Interest + Fees.
New balance: This is how much you currently owe on your credit card and is equal to your Previous balance + total charges — total credits.
It’s crucial that you carefully read your credit card account statement every month. It has vital information that you will need to manage your credit card.
Credit card reward points
If you follow the golden rule of managing a credit card, you will put yourself in a position to take advantage of one of the major perks of owning a credit card; reward points.
There are many different types of credit card reward programs, but the two most common are travel and cashback rewards.
Travel reward programs allow you to collect points for each purchase you make using that card. These points can typically be redeemed for flights, hotels, and vacation packages.
Cashback reward programs provide a cash rebate for each purchase you make with that card. These rebates are typically around 1%-2% of the value of purchases made on the card. Many rebate programs provide different cashback rates for various purchases. For example, some cards give a higher percentage of cashback at grocery stores and gas stations.
In addition to points and cashback, credit card reward programs also provide additional perks to the cardholder. For example, my travel reward card gives me free insurance coverage on rental cars.
A word of caution about credit card reward programs: these reward programs incentivize you to spend money. The more money you spend, the more points you get. You should never spend money simply to collect credit card points.
That might sound obvious, but you would be amazed how many people justify purchases they don’t need to make because “I get points.” Credit card companies are not stupid. They know that people respond to incentives. Use the reward programs, but don’t let them use you.
Another word of caution on credit cards that offer a reward program; don’t get fooled into paying a high annual fee for the privilege of collecting points.
Often, credit cards that have a reward program offer two different versions of the same credit card.
A version of the card with a less generous rewards system with a small or even no annual fee.
A version of the card with a more generous rewards system with a higher annual fee.
Let me repeat it, credit card companies are not stupid. They know that many people will take the card with a high annual fee for the sole purpose of collecting more points.
Depending on how much money you spend per year, it is possible that the more generous rewards program could justify the higher annual fee, but for most people, it’s best to stay away for a straightforward reason. The high fee credit card incentivizes you to spend more money.
Think about two versions of a cashback rewards card.
Card 1: Offers 1% cashback and has no annual fee.
Card 2: Offers 2% cashback and has a $120 annual fee.
You would need to spend $12,000 per year or $1,000 per month just to break even on card 2. This provides an incentive to spend at least $1,000 per month to justify the choice to go with the high-fee credit card. You may not even be aware that this is happening, but somewhere in your subconscious is a voice telling you to get the points.
When in doubt, choose the credit card with no annual fee.
While credit cards themselves are not evil, mismanaging a credit card can have devastating consequences on your finances. As long as you always pay off your balance immediately and opt for a card with a low or no annual fee, a credit card can be a valuable financial tool.
3. Personal loans and lines of credit
Unsecured personal loans and lines of credit are other forms of debt that people often abuse.
The term “unsecured” refers to the fact that there is no collateral attached to these loans. A mortgage is a “secured” loan, meaning the loan is secured against your home. If you don’t pay your mortgage, the bank can take your home.
This is not the case for unsecured loans and lines of credit, which is why they have a higher interest rate than a mortgage or other secured loans. The bank takes on more risk with an unsecured loan or line of credit, so they charge a higher interest rate to compensate themselves for taking that risk.
You might be wondering what the difference between a loan and a line of credit is?
A personal loan is a lump sum of cash. It is useful for financing a large, one-time purchase like a car. It can also be used as a way to consolidate higher-interest debt like credit cards. Payments on a loan typically begin as soon as you receive the money.
A personal line of credit is a financial instrument where you are granted the right but not the obligation to borrow money up to a maximum amount. For example, if you are approved for a $10,000 line of credit, you can choose to borrow between $0 and $10,000. You only pay interest on the outstanding balance of your line of credit.
Personal loans and lines of credit can be useful if you need to consolidate higher interest rate debt like credit cards and payday loans into a single monthly payment with a lower interest rate.
On the other hand, if you use personal loans or lines of credit to fuel consumption like buying a new TV or going on a vacation you can’t afford, they can get you into financial hot water.
4. Car loans
I am not a big fan of cars. They are most people’s second-largest expense in life and for most people, where they waste the most money.
I am also no fan of car loans because they trick people into buying a more expensive car than they need. Just because someone will lend you $30,000 to buy a car does not mean you can afford or need to buy a $30,000 car.
Sadly, this is precisely how many people make their decision on what car to buy. They buy the most expensive car for which someone will lend them the money to buy. Borrowing money and paying interest to buy something that will one day be worthless is not a smart financial move.
That is why The average car loan payment is over $550 per month. Take a moment and compare that number to the amount you save for retirement each month. If your car payment is larger than your retirement savings, you need to get your financial priorities straight.
Rather than going further into debt to buy a “cool” car, why not buy the crappiest (and safest) car you find and redirect the savings towards your financial goals?
5. Loans from family and friends
Not all debt comes from credit card companies or banks. Often times, people borrow money from their friends and family. It’s difficult to rank these types of loans because they have the highest variance in outcomes.
Borrowing money from close friends and family can work out great if you repay the loan in the agreed-upon timeframe. This could be a lifesaver if you need cash but can’t get a loan from a bank. Depending upon your relationship with the person lending you money, you might get a lower rate than the bank would charge.
However, there is a lot of risks involved in borrowing money from people you know, and it goes beyond financial risk. You risk losing your relationship with that person.
Lending money to a family member was the worst decision I ever made. Not only did I lose a lot of money, but things also got so ugly that I lost my relationship with that family member. We never reconciled and will never have the opportunity to do so.
There are some things in life more valuable than money, and relationships with the right people are one of those things. Never borrow money from friends or family unless you are willing to potentially sacrifice your relationship with that person.
6. Student loans
We are now officially out of “consumer loans,” which is when you take on debt to buy “Stuff” and are moving into “investment loans.”
Student debt is a tricky issue. On the one hand, it has never been more expensive to get a college education. That is why 70% of college graduates have student debt, and the average student loan is $37,000.
On the other hand, college graduates have the lowest levels of unemployment and earn more money than people who did not graduate from college.
Here are some stats from the Social Security Administration about the impact of education on lifetime earning potential.
Men with bachelor’s degrees earn $900,000 more lifetime earnings than male high school graduates.
Women with bachelor’s degrees earn $630,000 more than female high school graduates.
The numbers are even more lopsided for those who complete graduate school.
Men with graduate degrees earn $1.5 million more lifetime earnings than male high school graduates.
Women with graduate degrees earn $1.1 million more lifetime earnings than female high school graduates.
Education is an investment in yourself. I took on $50,000 in debt to complete my master’s degree, and it was one of the best decisions I ever made. It increased my income substantially and allowed me to easily get out of debt and quickly begin building wealth.
Whether or not student loans end up being good debt or bad debt depends entirely on you. If you don’t overextend yourself and leverage your education into a high-paying career, it can be a great decision.
If you flunk out of school or never pursue a career related to the education you received, then student loans are a waste of money, and going to college was a waste of time.
Anytime you invest in yourself, the outcome will be entirely dependent upon what you do.
In many circumstances, owning a home is an excellent financial decision. A mortgage allows you to buy an asset worth hundreds of thousands of dollars without having the money upfront.
As a form of debt, mortgages are as good as you will get.
The interest rate for mortgages is lower than any other type of debt you will find.
You have longer to repay the debt (up to 30 years) than any other type of debt you will find.
That being said, you mustn’t go overboard and buy a bigger house than you need. A bigger house means a bigger mortgage, which means higher monthly payments. If you have a four-bedroom house but only use one bedroom, you paying interest on three rooms you don’t use.
A bigger house also means higher property taxes, utilities, and maintenance costs. In the same way that a car loan can trick someone into thinking they can afford a nicer car, a mortgage tricks many people into thinking they can afford a bigger house.
Buying a home and taking on a mortgage is one of the most important financial decisions you are likely to make. You need to be smart about it. Buy the least amount of house you are comfortable living in and minimize the size of your mortgage.
8. Loans to buy income-producing assets
The best kind of loan is when that is used to buy investments that will increase in value and pay you income along the way.
Examples of income-producing assets;
Borrowing money to invest is called leverage. Leverage can increase your investment returns and your net worth, but it also increases your level of risk and, if misused (or if you simply have bad luck) can have disastrous financial consequences.
Using leverage to invest in real estate
There are two simple reasons many real estate investors have a high net worth.
They buy assets using other people’s money.
They get other people to pay their debts for them.
Real estate investors can buy properties worth hundreds of thousands of dollars using other people’s money. Most often, this means taking out a mortgage to buy a property.
Here is an example that illustrates the power of leverage in real estate investing.
Let’s say you buy a house worth $100,000 and used $20,000 of your own money and borrowed $80,000 in the form of a mortgage. After one year, the price of that home has increased to $105,000. What is your turn on investment?
Some people might say 5% ($5,000/$100,000), which feels right but is wrong. Remember, you only put down $20,000 and have a $5,000 return, which means you had a 25% return on your money ($5,000/$20,000). This is an oversimplification and ignores all of the costs associated with owning real estate, but illustrates the power of leverage in real estate.
The other added benefit of using leverage to invest in real estate is that if you have made a smart investment, your tenants will pay your mortgage for you. A smart real estate investment will be “Cash flow positive” from day one. Meaning you should be collecting enough rent to pay for the mortgage you used to buy the property and all of the other expenses associated with the property like maintenance, insurance, and taxes.
Using leverage to invest in the stock market
There are three ways to use leverage to invest in the stock market.
Using what is called “margin.”
Taking out a personal loan or line of credit.
Using the equity in your home.
Margin is money that is borrowed from an investment brokerage firm used to purchase an investment. The term margin is used because it is the difference (aka the margin) between the total value of your investments and the amount you borrowed from the brokerage. Any assets held inside your investment account are used as collateral for the loan.
Using margin to invest is very risky and is something that most people should never engage in. In addition to the interest, you need to pay on the loan, if the value of your investments drops too much, you could be subject to what is called a “margin call” where the broker calls the loan and demands you repay it.
While it is useful to know what margin is for educational purposes, it is not something I would ever recommend.
Another option to use leverage to invest in stocks would be to use a personal loan or line of credit. This is straight forward; You use the loan to invest in the stock market and deduct the interest against your taxable income. The problem is that it might be more challenging to get approved for a loan to invest in stocks, and you would likely have a relatively high-interest rate.
Finally, if you are a homeowner and you have enough equity in your home, you might be able to borrow against the value of your home to invest.
There are two possible ways to do this.
Refinancing your mortgage.
Taking out a Home Equity Lines of Credit (HELOC).
You already know what a mortgage is. It’s a loan against your home, which often has a fixed interest rate, pre-determined payments, and amortization schedule (when you are set to pay the mortgage off).
You may not be familiar with HELOCs, which is a line of credit that is secured against the value of your home. HELOCs typically have lower interest rates than unsecured lines of credit. The reason for this is because you are securing the line of credit against your home, meaning if you default on the loan, you could potentially lose your home.
For the vast majority of people reading this, it’s not worth the risk to use leverage to invest in the stock market. This is especially true if you are putting your home on the line, the potential benefits seldom outweigh the potential downside.
Taking out a loan to start a business
One of the most critical functions that banks play in society is lending money to entrepreneurs to start new businesses. The more people that start a business, the more wealth and jobs are created.
Owning a business and especially starting a brand new business is the definition of “high-risk, high-reward.” It’s a well-known fact that the majority of businesses fail. This makes them a very risky proposition. On the other hand, owning a profitable business is one of the fastest ways to generate wealth.
Most of the wealthiest people in the world built their fortunes by owning profitable businesses. However, for many entrepreneurs, the motivation to start a business is not strictly financial. They may be pursuing a particular passion or want to enjoy the flexibility that’s business provides. If a business is profitable, the owner can pay employees to run the business for them.
Any debt used to invest, whether it be in real estate, the stock market, or to start a business, is the best type of debt for two reasons.
The interest on that debt is typically tax-deductible.
The debt is attached to an asset that produces income, unlike consumer debt which is attached “to stuff” that has no financial value and generates no income.
That being said, using debt to invest or start a business still involves a high degree of risk. If you overextend yourself or simply have bad luck, you could lose the asset you invested in and be stuck with the loan. That could have disastrous results.
Anyone considering using debt to invest should only do so after a great deal of planning. Preferably that planning should be done with a financial planner.
The importance of a good credit score
Your credit score has a massive impact on your relationship with debt. The better your credit score, the more likely you are to get approved for a loan, and the lower the interest rate on that loan will be.
In the U.S, credit scores range from 300–850, while in Canada, they range from 300–900. Here is what is considered a good and bad credit score.
300–649 Is considered a “bad” credit score.
650–699 is considered a “fair” credit score.
700–749 is considered a “good” credit score.
750+ is considered an “Excellent” credit score.”
Let’s consider the example of three people who have the same job, make the same income but have different credit scores who are all applying for a mortgage.
James has a credit score of 450, which is considered to be bad.
Jill has a credit score of 678, which is considered to be good.
John has a credit score of 808, which is considered to be excellent.
They all apply for a mortgage with the same bank.
James is declined and unable to buy the home of his dreams.
Jill is approved for a $240,000 mortgage, a 3.8% interest rate.
John is approved for a $240,000 mortgage at a 2.5% interest rate.
Jill is clearly in a better position than James. The difference between a fair credit score and a bad credit score could be the difference between getting approved for a loan or not.
But how much better off is John compared to Jill? How much will he save on interest due to his excellent credit score?
John will pay $101,384 in interest over the next 30-years.
Jill will pay $162,587 in interest over the same time frame.
In this example, the difference between an excellent and fair credit score is $61,203. That is additional money that John could be using to either invest or make additional principal payments against his mortgage, saving him even more in interest and having his mortgage paid off sooner.
How to improve your credit score
Clearly, having an excellent credit score should be everyone’s goal. But what if your credit score is terrible right now? How does someone improve their credit score?
Your credit score is primarily determined by the following factors.
Your history of paying bills on time.
How far back your credit history goes.
The amount of debt you are currently carrying.
How much of your credit limits you are currently using.
The mix of credit accounts on your file.
The number of credit inquiries/applications you have made.
So, if you want to begin improving your credit score, the first step is to simply pay all of your bills, including your loan payments on time. Make a promise to never be late on a bill payment again. This is both the most important factor in improving your credit score in the long run and the action that is most in your control.
The length of your credit history also plays a role. If you don’t have any history of credit use, applying for a credit card (that you will use responsibly) might be an excellent way to begin establishing a credit history.
Another important factor impacting your credit score is what is called your “utilization ratio.” This is a measure of how much of your available credit you are currently using.
Let’s say you have a credit card and a line of credit.
The credit card has a $10,000 limit, and you have a $7,000 balance.
The line of credit has a $50,000 limit, and you have a $10,000 balance.
That makes for a total of $60,000 in available credit and a combined balance of $17,000
That works out to a 28.3% utilization ratio. A low utilization ratio has a positive impact on your credit score.
To improve your utilization ratio, you can do two things.
Begin paying off debt.
When you pay off debt with a revolving balance, don’t close the account.
In the above example, if you were able to pay off the balance on your credit card and your line of credit, but you did not close either account, it would bring your utilization rate down to 0%. You would have a total of $60,000 available to borrow, and you aren’t using any of it. That shows lenders that you know how to manage credit responsibly.
You also want to make sure that you aren’t applying for too many credit products. If you get denied for a loan due to low credit, the worst thing you can do is turn around and make five more applications at different banks. The more credit inquiries (loan applications) you make, the worst it will be for your credit score.
You shouldn’t be afraid to apply for credit when you need it, but be careful not to make too many applications in a short period.
How to get out of debt
Now for the part that anyone living in debt has been waiting for, let’s discuss how to pay off that debt. Two proven strategies will help you pay off debt fast.
The snowball method.
The avalanche method.
What is the snowball method?
The snowball method is a debt repayment strategy in which you focus on paying off your debt with the smallest outstanding balance. It’s a four-step process.
Step 1: List your debts from smallest to largest.
Step 2: Make minimum payments on all your debts except the smallest.
Step 3: Pay as much as possible on your smallest debt.
Step 4: Repeat until each debt is paid in full.
Why people love the snowball method
The snowball method is the most popular debt repayment strategy because it leans into a simple truth about personal finance; habits and actions are more important than technical knowledge.
The psychology behind the snowball method is that paying your loan with the smallest balance first enables you to get your first loan paid off as quickly as possible. Once you pay off that first loan, you gain confidence and begin to believe that you can pay the rest of your debts. This provides you energy and gets you excited to keep going.
I like the snowball method because it gives people hope. Many people believe that their current circumstances are “how it will always be.” Having an early win and seeing a loan completely paid off can begin to change someone’s belief about what is possible for them to accomplish.
What is the avalanche method?
The avalanche method is a debt repayment strategy in which you focus on paying off the loan with the highest interest rate first.
Here are the four steps to paying off your debts using the avalanche method.
Step 1: List all your debts from the highest interest rate to the lowest interest rate.
Step 2: Make minimum payments on all your debts except the debt with the highest interest rate.
Step 3: Pay as much as possible on your debt with the highest interest rate.
Step 4: Repeat until each debt is paid in full.
While the snowball method is about psychology, the avalanche method is bout efficiency.
Why the avalanche method is effective
If the psychological aspects of paying off debt aren’t a concern for you and don’t need to have that feeling of a quick win, the avalanche method might be a good fit for you.
The avalanche method will allow you to pay off your debt as quickly as possible while paying the least amount of interest.
Snowball vs. Avalanche methods a detailed breakdown
I’ll use a hypothetical example to demonstrate precisely how you can use the snowball or the avalanche method to pay off debt.
Let’s pretend you have the following debts.
Credit card 1: $20,000 balance at a 22% interest rate.
Credit card 2: $6,200 balance at a 16% interest rate.
Credit card 3: $7,600 balance at a 17% interest rate.
Student loan: $44,000 and 8% interest rate
Line of credit : $3,500 balance and 7% interest rate
Total debt: $81,300
Your goal: Pay off all debts in six years.
How to pay off $81,300 in six years using the snowball & avalanche methods
The first step to paying off your debts regardless of whether you use the snowball method or the avalanche method is to calculate your minimum monthly payment on each loan.
After reviewing your monthly statement for each loan, you found the following minimum payments;
Credit card 1: $200/month.
Credit card 2: $62/month.
Credit card 3: $76/month.
Student loan: $350/month.
Line of credit: $99/month.
Total minimum monthly payments: $787/month
How to use the snowball method
The order in which you would pay off these debts using the snowball method is as follows.
Line of credit
Credit card 2
Credit card 3
Credit card 1
If your goal is to pay all of your debt off in six years, you will need to contribute $1,587 per month towards your debt. Initially, $787 will go towards minimum payments and $800 towards additional principal payments on the line of credit.
After month four, the line of credit will be paid off. Then you will take the $99 minimum payment and the $800 of additional principal payments and use that money to pay an additional $899 towards credit card 2 while maintaining minimum payments on your other debts.
After month 11, credit card 2 will be paid off. Then you will take the $62 minimum payment and the $899 of additional principal payments and use that money to pay an additional $961 towards credit card 3.
After month 20, credit card 3 will be paid off. Then you will take the $76 minimum payment and the $961 of additional principal payments and use that money to pay an additional $1,037 towards credit card 1.
After month 43, credit card 1 will be paid off. Then you will take the $200 minimum payment and the $1,037 of additional principal payments and use that money to pay an additional $1,237 towards the student loan.
After 72 months (six years), the student loan will be paid off, and you will be debt-free.
During the six years, you would have paid $32,191 in interest using the snowball method.
All of this is summarized in this table.
How to use the avalanche method
The order in which you would pay off these debts using the avalanche method is as follows.
Credit card 1
Credit card 3
Credit card 2.
Line of credit
If your goal is to pay all of your debt off in six years, you will need to contribute $1,562 per month towards your debt. Initially, $787 will go towards minimum payments and $775 towards additional principal payments on credit card 1.
After month 26, credit card 1 will be paid off. Then you will take the $200 minimum payment and the $775 of additional principal payments and use that money to pay an additional $975 towards credit card 3 while maintaining minimum payments on your other debts.
After month 35, credit card 3 will be paid off. Then you will take the $76 minimum payment and the $975 of additional principal payments and use that money to pay an additional $1,051 towards credit card 2.
After month 40, the line of credit will be paid off. Even though you had not yet made any additional payments on the line of credit, 40 months’ worth of minimum payments were enough to clear that debt. So, you take the $99 minimum payment that was going towards the line of credit and apply that to credit card 2. At this point, you are paying $1,230 towards credit card 2.
After month 42, credit card 2 will be paid off. Then you will take the $62 minimum payment and the $1,231 of additional principal payments and use that money to pay an additional $1,293 towards the student loan.
After 72 months (six years), the student loan will be paid off, and you will be debt-free.
During the six years, you would have paid $28,791 in interest using the avalanche method.
All of this is summarized in this table.
So, which is better the snowball or the avalanche method?
Both the snowball method and the avalanche method would have you debt-free in six years.
If you used the avalanche method, you would save $3,400 in interest payments.
If you used the snowball method, your first loan would be paid off two years sooner than if you used the avalanche method.
If your measuring stick is getting debt-free in the most efficient way possible, the avalanche is the better strategy.
If you need to get a “quick win,” pay off your first loan and keep going than the snowball method will work best for you.
Which method you choose is not very important. What matters is that you stick with whatever strategy you pick and see it through to the end.
Debt is not evil
As we have covered, debt is not evil. It is simply a financial tool. It is our miss management of that tool that causes so much pain and suffering.
It’s important to remember that some debt is better than others. Taking on debt simply means you wanted to buy something you don’t have the cash for today. Debt used to fuel consumption will lead to financial pain. Debt used to fuel investment either in yourself or in assets that produce income has the potential (but no guarantee) to help you build wealth.
Your credit score is incredibly important and could be the difference between being approved for a loan or not. The most important step you can take towards improving your credit score is to pay all of your bills, especially your debt payments on time.
There are two proven strategies to pay off debt; the snowball and avalanche methods. The snowball method will allow you to get an early win by paying off your first loan quickly. The avalanche method will minimize the interest you pay on your journey to becoming debt-free.
Still, feel stuck or confused?
If the idea of crunching these numbers and figuring all of this out is stressing you out, then I invite you to enroll in my personal finance course "The 30 Day Blueprint to Successful Money Management". Where you will receive a custom-built excel workbook that crunches all these numbers for you and where we dive deep into these topics in video-based lessons. Learn more here.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.