I don’t mean to be a ‘Debbie-downer’ but we really need to talk about debt. Please don’t click away… we know paying off debt is a very common money goal and we’re going to attempt to give you some strategies to help you do it. Don’t feel overwhelmed, it’s estimated that the average Australian has more than $168,8001 in personal debt (ooft) including home loans, credit cards and student loans.
But there’s some good news, not all debt is bad. Debt for example can help fund education (a great investment, as generally it may lead to longer term earnings) and homes which you otherwise may not have been able to afford from the outset. Although, generally, it’s recommended not to have debt that exceeds 25% of your take-home pay. Generally, it may be good to think about debt like this: good debt is when you borrow money for the purpose of buying an asset that will increase in value or bring further income. On the other hand, bad debt will come about when you spend money that doesn’t further your financial position.
We’re going to talk about two strategies that may assist in paying off debt. They’re called the avalanche and snowball methods (very randomly snow related but bear with me).
Paying off debt – the avalanche method
The avalanche method can also be referred to as ‘debt-stacking’ which is a debt-paydown method which is generally designed to help you pay as little as possible in interest. How the avalanche method works:
- Make a list of all your debts, don’t forget things like student loans, credit cards, car loans etc. Write them all down, along with their interest rate. (Yep, even those afterpays!)
- Put them in order from highest interest rate to lowest interest rate. If you have two debts that have the same interest rate put the one with the lower outstanding balance higher on the list.
- Keep paying all the minimum payments on each debt (otherwise you’ll get hit with those pesky late fees, which may also take a hit to your credit score).
- Put any money you can find in your budget toward the debt the top of the list. This is because the debt at the top of the list is the one with the highest interest rate (that is, more detrimental to your financial position).
- Keep going until #1 is completely paid off (we believe in you). Then, yep, you guessed it, start using the same amount you used to pay off #1, to start paying off #2. That way the money you’re putting toward debt won’t change month-on-month.
- Keep going! Generally, we recommend using your efforts to pay off debts that have an interest rate greater than 5%. Generally, this means paying off ALL credit cards (as the average credit card interest rate today is 16.58%!2 And for the debts less than 5%, just keep paying the minimums.
Why shouldn’t I worry as much about debt with less than 5%?
This is because instead of using your money to pay off debt, you could consider using it to invest. For example, Australian shares (between 1900 and 2019) on average has returned and average of 11.8% or at least it has historically (past performance isn’t a reliable indicator of future performance).
Paying off debt – the snowball method
The debt snowball method actually works nearly the same as the debt avalanche method, with just one difference; instead of putting your debts in order from highest interest rate to lowest interest rate, you order them from smallest outstanding balance to largest outstanding balance, and then follow the steps 3-6 the same way.
Why the difference?
Well with the snowball method, you’ll have your first celebrations of paying off a complete debt in full a lot sooner, as you’re paying the smallest balance first (ahem, get onto those afterpays!). As your payments are snowballing (in a good way, as they get bigger and bigger with every debt you pay off) you get to that positive reinforcement a lot sooner. The idea is that our brain likes to be rewarded so you will likely keep up with your plan for the long haul.
And as we love you paying off any debt, there is one downside to the snowball method. It doesn’t reduce your interest payments as quickly as the debt avalanche method which means you will likely pay more interest overall. BUT it could help you get out of debt faster as the debt snowball method may do better job of motivating you.
So… which method should I chose to pay off that debt?
Ultimately it is up to you and will most likely come down to preference. You could keep motivation at a high with the snowball method or move the debt mountain down faster, like an avalanche, obliterating those pesky interest payments along the way.
Remember if followed strictly, the avalanche method ensure you pay less interest which therefore ensures you pay less overall.
Another point to consider when paying down debt is to make sure you pay off your ‘non-deductible debt’ first and your ‘deductable debt’ later. Non-deductible debt means the interest you are paying is not tax deductible (like on your personal credit card for example). Deductible debt means the interest you are paying is (at least to some extent) tax deductible, like when borrowing to acquire shares or an investment property (home loan).
Generally, we recommend paying the least amount of interest as necessary, thus we’d lean toward the avalanche method but if you need the constant positive reinforcement then we love the snowball method for you too. However, individual personalities and motivations can come into play… Ultimately;
The most important thing is, you’re knocking out those debts, one at a time and taking charge of your financial future.
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