OK, so you have come to terms with the debt you have, and you have some extra money in your cash flow to allocate toward extra debt payments.
(See my “Should I Make Extra Debt Payments or Save?” blog post about how to allocate extra cash flow.)
Now the question becomes: What debt reduction strategy is actually best?
Well, there are a few debt-reduction strategies you can follow, but here are two of the most popular:
The Snowball Method. This is the method personal finance and debt-reduction guru Dave Ramsey preaches. With this strategy, you start by paying the minimum on all debts and allocate additional debt payments toward the debt with the lowest balance. This method allows for immediate gratification, motivating you to keep working on paying off your debts. But because the debt with the lowest balance may not necessarily be the one with the lowest interest rate, you might not be saving as much interest over time using this method. However, since a lot of financial success comes from your behaviors, this method allows for some quick wins—which may help you stay motivated over the long haul.
The Avalanche Method. This method suggests that you allocate any additional debt payments toward the debt with the highest interest rate while simultaneously paying the minimums on the rest of your debts. You continue this method—adding the entire additional payments to the debt with the highest interest rate debt—until the debt is completely paid off. Then you move to the next-highest interest rate debt and allocate any additional debt payments toward it, while still paying the minimums on the rest of your debts. Mathematically speaking, this strategy will save you the most money over time, since you’ll be paying the higher-interest debts before lower-interest ones. However, it may not allow for the immediate gratification of the Snowball Method.
So which is better? Well, I usually encourage clients to follow a combination of both methods. Start by paying off the debt with the lowest balance, then move on to the debts with the higher interest rates and continue to stick to the Avalanche Method from that point forward. And of course, it’s best to work with a financial planner who can help you design a strategy that is comfortable and efficient for you given everything else that is going on in your life.