One of the ways that you can improve your financial situation, as well as improve your credit, is to pay down debt. Paying down debt can boost your credit score, and it puts you in a better financial situation. As long as you have debt — especially high priced credit card debt — you are paying money right into someone else’s pocket through interest.
As you decide to pay down your debt, you need a plan. One of the most popular debt payment plans out there right now is the debt snowball method popularized by Dave Ramsey. You can also use an alternative to the debt snowball, known as the debt avalanche.
What is the Debt Snowball?
The concept behind the debt snowball has been around for years, even before Dave Ramsey popularized it, and gave it a name. It’s fairly straightforward:
- Figure out how much money you have each month to contribute to debt reduction. This is your debt reduction payment.
- Order your credit card debts, starting with the smallest balance first, and listing them up to the largest balance.
- Pay your minimum balance on all your balances.
- Take the amount you determined you could pay in step 1, and apply it to the smallest balance, on top of the minimum.
- Once your smallest balance is paid off, take the total you have been paying (minimum + debt reduction payment) and apply it on top of the minimum payment of the next-smallest balance.
This method is popular because you see fast results. You pay off your smallest balance relatively quickly, and feel a burst of excitement that you have accomplished something. The theory is that you are excited to have paid off the debt, and read to tackle the next debt. Plus, your payment toward each card grows as you go down the line, accelerating your ability to pay off debt and attack the higher balances later.
Variation: Debt Avalanche
For the most part, the debt avalanche is the same as the snowball. The main difference comes in step 2. Instead of ordering your debts from smallest to biggest, you order them starting with the highest interest rate.
With this method, you actually pay off your debt faster, and pay less in interest. This is because higher interest rates slow your rate of repayment, since more of the payment goes to interest. By starting with the highest interest rate, you rid yourself of the worst offender. The smaller rate balances don’t grow as fast, and they are easier to pay off as you move down the line.
Mathematically, the debt avalanche makes more sense. However, it can be a slow start if your highest interest rate is also attached to one of your higher balances. Some people become discouraged with the debt avalanche method and give up. Only you can determine what will work best for you. However, if you are mostly interested in paying off your debt a little faster, and saving money in interest, the debt avalanche is usually preferred to the debt snowball.
What do you prefer?