The average American household has $98,315 in debt. If you remove all of the people who are debt free, the average household with debt has $132,086 in debt (Nerd Wallet).
How does your debt rank with the average American? Does it make you feel better? Worse?
Before we get into specific debt repayment strategies we need to understand the basic process of paying off debts in general. The basic steps to approach paying off your debt are:
- Pay the minimum payment on all your debts. This one is not optional. Not paying at least the minimum payment on all your debts equals much more trouble down the road. This is where you can consider debt consolidation and other forms of restructuring if need be.
- Track your spending. Know where your money is going each and every month. Here is a list of 12 free apps to help (I use Mint).
- Cut your spending. If you've successfully tracked your spending, it's inevitable that you'll find something that appalls you. When my wife and I tracked our spending for the first time we couldn't believe how much we were spending each month on eating out. Find these areas and cut back.
- Budget. Now that you know where your money has been going, it's time to plan for where it should be going. Here's some info on how to get started. In doing your budget, determine how much you can allocate to debt repayment above the minimum payments.
- Choose a payoff strategy and allocate accordingly. This is where the jury seems to be out on what to do. Many people have multiple sources of debt and have to decide the best way to pay them all off. There are many strategies paying off debt from various sources, but three strategies consistently rise to the top in terms of people implementing them.
So what are the three methods, and which is right for you?
Strategy 1: The Balance Method (Debt Snowball)
This strategy was made popular by Dave Ramsey and has garnered multitudes of followers that are loyal to Dave and his sage wisdom for the masses. This method is defined by ranking all of your debt by the size of the debt. From there you still pay the minimum payment on all your debts, but you allocate everything else that you can towards paying off the smallest balance first. Then moving on to the next smallest, and so on.
Trent Hamm wrote a great article on his thoughts on the Dave Ramsey snowball approach, and you can find it here. Like Hamm, I greatly respect and admire what Dave Ramsey has done for many, many people, but you have to keep in mind that he is speaking to a very broad audience and has to make some generalizations.
The snowball method is deeply rooted in psychology. It uses the feeling of accomplishment that comes with having a debt eliminated from your plate entirely to fuel your motivation to eliminate the rest. The reason this method is called the "snowball effect" is that when you eliminate one debt, you allocate all your money that you were paying towards eliminating that debt towards the next debt in line, increasing the amount you are paying on each successive debt balance.
Strategy 2: The Interest Rate Method
In this method, you still pay the minimum payment on each debt, but the difference is that you rank each debt by the interest rate, rather than balance, associated with it. In this method, you still "snowball" the amount you had been paying on prior debts, but the process doesn't always happen as quickly since the lowest balance debt is not always prioritized first.
Logically and mathematically speaking, this method is proven to lead to the least amount paid over the life of all your debts of any approach.
The reason behind this? Your interest rate on your debt is the cost at which the money is borrowed. The longer your highest interest debt stays active, the more and more interest that you accumulate over the life of the loan (and this isn't the good kind of interest like from your investments). By focusing on high-interest rate debt first, you minimize the impact these rates have on how much you end up paying. Compound interest is a powerful thing, either working for or against you.
So if this method is mathematically the best, why doesn't everyone use it?
Psychology. Some people drive home on a route that they know to be slower than other ways, but they enjoy the drive of the slower route more. In the same way, some people may know that they will be paying more for their debt in the long-run, but like the feeling of having one less bill in the mail. Comfort always comes at a cost. In the driving metaphor the cost is time, and in regard to debt, it's usually money (and often time).
Comfort always comes at a cost.
Strategy 3: The Credit Limit Method
This strategy is my least favorite out of the three, so I will spend the least amount of focus on it. The difference in this strategy is ranking your debts by their credit limit. Naturally, your credit cards (lower credit limits) usually rise to the top in this method and your debts like your home and student loans (indefinite credit limits) fall to the bottom. This method is geared towards building and protecting your credit by trying to keep your credit utilization rate at the lowest possible. Your utilization rate is the amount of debt that you have compared to your total allowable limit.
The reason that I am not as big of a fan of this method is that it ignores the cost of borrowing money (your interest rates) and focuses on setting you up the best to borrow again in the future. This seems like the equivalent of breaking your arm in a downhill skiing accident and asking the doctor to put a less-than-optimal cast on your arm so you can compete in an even more dangerous event next year. This method may help you to get a better interest rate in the future, but I'm all for debt reduction strategies that get to the root of the problem: unnecessary spending and living beyond your means.
Debt reduction is all about living within your means and eliminating habits of uncontrolled spending.
So, Which Method Is For Me?
If you want to pay off your debt in the most efficient way possible and have the discipline to pay off your debts with the highest interest rate first, even if they don't have the lowest balance, then the Interest Rate Method is likely the best way for you. This way will lead to you paying the least amount over the life of all your debts and is typically my recommendation to people.
If you are not as disciplined or have a hard time making a plan and sticking to it, then the Snowball (Balance) Method might be the best for you. This way helps you to have some smaller "wins" earlier on that can help motivate you to continue.
If you're concerned with your credit score and really want to focus on keeping it as high as possible, then the Credit Limit Method is the best way for you. The method will lead to the fastest decrease in your credit utilization and should help your credit score most readily.
There is not necessarily a one-size-fits-all answer to this question and it is important to consider your goals and personality before drawing up a debt repayment plan. Feel free to reach out with any questions or help with developing a debt game plan of your own.