How to pay off debt quickly? The three methods.

Dear fellow Richful Thinkers,

There are THREE methods to paying off debt. I have spoken about two of them and they are widely spoken about on other personal finance blogs: Debt Snowball and Debt Avalanche.

However, there is another one, it is a cost-effective type of debt payoff. I like calling it Debt Melting. 

These three can be used together, as you may want to start off with the Debt Snowball and realize you want to try another way. This may help prevent burnout, since it can be easy to lose steam as you are paying off your debt. 

We are going to use Mary as an example. Mary has 3 debts of with varying amounts and interest rates 

  1. Credit card debt of $5,000.00 with an APY of 10%, this is a revolving debt so it has no set end due date.
  2. Student Loan of $50,000.00 with an APY of 1%, this is a 10-year loan.
  3. Loan of $1,000.00 with an APY of 4%, this is a 12-month loan.

Debt Snowball

The debt snowball method has been popularized by Dave Ramsey and his baby steps. It is essentially you take the lowest balance, regardless of the interest rate and you pay it off as quickly as possible (Gazelle Intense), all while paying the minimum balances on everything else. Once that is paid off, you pay the next one down until you have paid off the entire debt.

This approach is brilliant because it focuses on human psychology. There is an emotional tie to money, which is why it is personal how one approaches their finance. Math is not a focus here because people do not go into debt because they do not understand math, it is because they have an emotional tie to the purchases and it creates an issue of buying items they cannot afford. This method takes math completely out of the equation.

Since it is focusing on human psychology, it creates a momentum because you are seeing the successes of paying them off. Essentially being like a to-do list, and that feeling of success in completing one allows you to continue the momentum to pay them off.

So, in this scenario Mary would pay off her debt as follows:

 3. Loan of $1,000 

1. Credit card debt of $5,000

2. Student Loan of $50,000 

Debt Avalanche

Debt Avalanche is the opposite of the snowball, you focus on the highest interest rate rather than the lowest balance. In theory, those that have the highest interest rate also mean you are paying the most interest. So, it does take some math into play, however, you are still having an emotional tie to your debt and how you approach to pay it off and it is a somewhat non-math approach. 

In this scenario, you are also taking one of the tenets of the Debt Snowball approach since you are Gazelle Intense in paying off the first loan and only paying the minimum for the others and following this method until all are paid off. 

In this scenario, Mary would pay…

1. Credit card debt of $5,000

3. Loan of $1,000

2. Student Loan of $50,000

Cost Effective Approach (Debt Melting)

This method is purely based on math, rather than emotions. So, when wanting to apply this method you must ask “What will cost me the least amount of money in the long run?” The answer to this question is looking at the whole picture, not just the interest rates or the amount due.

For instance, 1% on $50,000 is the same as 10% on $5000.00. They have different principals and different interest rates but they both equal about $275 in interest on a yearly basis. However, factors like fees, capitalized interest, etc., can affect this number.

So, if you are going to take the cost-effective route, you would want to make sure you pay the least interest possible.

Mary in this scenario would start off with paying the credit card quickly. It is revolving debt, so there is no final due date, however, if Mary decided to pay the minimum over 10 years then she will have paid $2,929.04 in interest. 

If you apply the same thinking to the student loan, Mary will have paid $2,562.47 in interest. Then considering the $1,000.00 loan, which only 12 months, the interest is $21.80. So, this one can be left to only pay the minimum as the interest paid is significantly less.

So Mary would prioritize her debts as  follows:

  1. Credit Card debt of $5,000
  2. Student Loan of $50,000
  3. Loan of $1000

I used the calculators at Bankrate to do these calculations.

Other Finance posts at Richful Thinker

The End

What do you think? Is there one you apply to your debt, or do you find yourself doing more of a mix?

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