When you get a loan, your loan terms provide the details of your repayment structure. For example, it’s clear that you are not only responsible for repaying the loan but that you have to do it in a certain amount of time. But for many people, it’s essential to become debt-free as quickly as possible. And the best way to do that is by accelerating payments. Debt snowball vs. avalanche is a common debate for people looking for strategies to pay off their debts such as installment loans. Read on to learn more about both!
Accelerated payments are voluntary payments that a borrower pays in advance on their loan. These additional or more oversized payments reduce the outstanding balance of their loan more rapidly. These payments are made at a higher rate than usual and can be made as often as you would like. Accelerated payments are a common technique for borrowers in a variety of economic contexts. For example, home mortgage loans often allow borrowers to make higher than mandated payments to pay off their principal more quickly.
If you want to repay your loan fast, there are a couple of strategies you can use. This post will examine both of them: The debt snowball method and the debt avalanche method.
Your choice between the two may come down to one straightforward question: How fast do I need to pay this loan off? While either of these methods will get you to a debt-free life quicker, they both have repercussions that will affect your life right now.
Want to learn how? Of course you do—this is essential stuff!
If you’re tired of being in debt and want to eliminate it, keep reading. We’ll tell you what you need to know about the debt snowball vs. avalanche debate. But first, let’s take a look at what gets many high-interest credit cardholders in trouble in the first place: The monthly minimum payment.
The minimum monthly payment is the lowest amount you need to pay each month to remain in good standing with your credit card company. But don’t get too excited; it’s the least you need to do to have a good repayment history.
For many borrowers, minimum payments can give a borrower a manageable repayment structure. However, a minimum monthly payment may seem like a fantastic deal for the first-time credit cardholder. For example, after charging thousands of dollars, they may see a monthly minimum payment due that’s far less than $100.
Having a regular expense that is due at the same time every month is excellent for monthly budgeting. However, there are a couple of facts about making minimum payments that many borrowers don’t realize.
Minimum Payments = Long-Lasting Debt
Making minimum payments means you’ll be paying off your debt for a long time. A long, expensive time, that is.
Minimum payments are designed to be conveniently affordable. Credit card issuers generally require you to pay a fixed amount or a percentage of the balance, whichever’s more significant. Often, the amount due is 1% or 2% of the balance plus any fees and accrued interest.
Minimum Payments = Maximum Interest Charges
The minimum payment barely eliminates last month’s interest. And remember, every item you purchase on your credit card accrues interest. So, the longer you keep charging things to your card, the larger your overall balance will grow.
If you’re want to estimate your interest charges, take your annual interest (APR) and divide it by 12. Then multiply that number by your Balance (or, if you’re still using your credit card, take the average monthly balance). For example, let’s say you have a 24% APR on a card that carries a limit of around $5,000. That means your monthly interest would break down to 2%. And with a $5,000 balance, you would owe about $100 in interest for each month. If you are making a monthly minimum payment of less than $100, you dig yourself deeper into debt.
On the other hand, if your credit card has a 0% APR, your overall balance can be less affected by paying just the monthly minimum.
Minimum Payments = Credit Score Damage
While it may cover the interest on purchases made within a billing cycle, monthly minimum payments don’t cover all your earned interest. Many people overlook the fact that interest is compounded daily on the typical credit card debt.
More interest means an increase in your balance, which in turn will raise your credit utilization ratio. The higher your credit utilization, the lower your credit score can be. And with a low credit score, you can be locked out of opportunities for future loans and credit lines.
To measure your utilization, divide the balance of your credit card by your credit limit. For example, if you have a $250 balance on a credit card with a $1,000 limit, your credit utilization ratio is 25%. A good general rule of thumb is to keep your credit utilization under 30%.
When Should You Make Just the Minimum Payment?
Anything can happen during the life of a loan. Anything from emergency medical needs to sudden job loss can throw off your payment plan. In those times, paying the monthly minimum payment can keep your loan’s interest under control. In addition, making a monthly minimum payment will help you avoid finance charges and late fees. These types of added costs can cause credit card debt to skyrocket with every billing cycle, so it’s critical to avoid them whenever you can.
So, now that you know a little more about minimum payments, you might be able to see how they end up doing two things:
- Keep you in debt longer
- Cost more money
If you can handle it, immediate repayment plans can eliminate both of those problems. The debt snowball and Debt avalanche methods are strategies that tackle debt in different ways. The one that will work best for you will depend on your amount of debt and how you want to handle it.
Debt Avalanche Method
The debt avalanche method is a better option if you are in a high-interest debt situation, like having significant balances on two or more credit cards with high APRs. The debt avalanche approach maximizes the effectiveness of one’s funds, allowing the highest interest rates to be taken care of first and then continuing to trickle down the list.
The first step in launching a debt avalanche program is to map out all of your financial obligations and all of your monthly expenses and designate an amount of your monthly income that is available to pay debts. This amount should come from any funds not currently obligated for living expenses such as rent, grocery, daycare, or transportation.
After making the minimum payments on all the accounts, apply the remaining money to the credit card balance with the highest interest rate. After that card’s balance is paid, start the process again with the next highest debt.
Using the debt avalanche method can save you the most in interest payments. And eliminating the most significant portions of your debt will relieve a lot of financial pressure. The best way to use the debt avalanche method is to commit as much money as you can at the beginning. You will probably want to use more than 10% of your monthly income for this process.
In this system, debts are not paid off in chronological order but rather by the debt. Though this technique requires more work and financial management, it can potentially build equity in homes and cars.
Debt Snowball Method
After seeing the advantages and disadvantages of the debt avalanche, some people prefer to go with the debt snowball technique. The debt snowball method may be best for those just starting to pay off their loans and reduce overall payments each month.
The debt snowball method is about paying off the smallest amount of debt first while still making payments on other debts. Here’s how you get started with applying the debt snowball method:
First, review all of your debt to get the total amount needed to make every minimum payment. Set that money aside in your budget. Then, order the amounts from smallest to largest. Unlike the debt avalanche, the debt snowball method does not prioritize interest rates. Take the money that you have allocated for your debt and put it all towards paying off the smallest debt that you have. When that debt is paid, you move to the next smallest debt on the list.
Although interest will accrue on your other debts, quickly eliminating one piece of it can be motivating. For many, debt can feel like a burden that they don’t know how to start lifting. Clearing one account can be the encouragement that you need to stay focused on becoming debt-free.
Tackle Credit Card Debt: Debt Consolidation Loan
The debt snowball method and debt avalanche method are both viable ways to pay down your debt. But ultimately, you still have to manage those payments to make sure you stick to your schedule. And if you are paying down multiple accounts, managing them can get stressful pretty quickly. That is one of the many reasons why people turn towards a third option: debt consolidation loans.
If you are looking for a simple way to handle debt management, a debt consolidation loan personal loan may be your answer. These personal loans let you lump balances from a high-interest credit card with other debts so that you can simplify your repayment plan.
You may want to consider a debt consolidation loan if you have:
Multiple Credit Cards
A debt consolidation loan can add stability to your repayment efforts. For example, most people work with an APR of 18%–24% with a high-interest credit card debt. However, the average personal loan interest rate is just 9.4%. So, depending on the number of cards you have, a debt consolidation loan could save you hundreds or even thousands of dollars in interest alone.
A Good Credit Score
As we mentioned earlier, a high credit card balance can dramatically affect your credit score. With a debt consolidation loan, you can pay off credit card balances and focus on single monthly installment payments. Making monthly payments on time will positively impact your payment history—which is the #1 factor that any creditor or lender will review. However, it’s important to note that a consolidation loan will cause a temporary dip in your credit score, as it requires a hard inquiry into your credit report.
Having the opportunity to secure a personal loan or line of credit can be a true blessing. Access the ability to spend when you need to is essential when cash on hand is nonexistent. But, it’s important to remember that whatever you borrow must be repaid. And repayment means building a schedule that can work for your budget.
Regardless of the repayment strategy you choose, be sure to choose one. Making a plan to handle your debt will help you focus on eliminating it. Keeping your debt in check will allow you to pay it down efficiently while also showing creditors a high level of financial responsibility. Learning good debt management will, in the long run, help you become debt-free.