On the journey to Financial Independence (FI) one of our first key steps is paying down debt so that we can then start saving money and investing. To help get you going on this, we’ll do a deep dive here on debt paydown strategies that actually work!
We’ll also cover some additional tactics that can help you accelerate the paydown of debt.
But first, why is it important to paydown debt?
In general, carrying a lot of debt limits our financial flexibility. Monthly principal payments and interest charges can grow to consume a large amount of our monthly income, leaving little left over to pay for the essentials let alone saving and investing.
Basically, having too much debt is a major roadblock on our path to growing wealth, and achieving FI.
In a recent article, we referred to certain types of debts as “bad debts”. [Link] With our goal of growing our net worth consistently over time, we’ll want to eliminate any “bad debt” we have. This will allow us to funnel our monthly surplus towards saving and investing.
Now, let’s get to those debt paydown strategies!
Snowball method
With the snowball approach we would target the smallest balances first for rapid paydown, regardless of their interest rates. At the same time, we continue paying the minimum payments on our other credit cards and loans. Once we’ve paid off the first balance, we move on to the next largest balance and continue until they are all paid in full.
With this strategy we get positive momentum early on as we see the number of outstanding debts quickly reduced. This can help to keep us motivated and focused on achieving our goal.
At the same time, as debts are eliminated one by one, the amount of money we have available to target the next debt grows and grows… just like a rolling snowball.
Avalanche method
The Avalanche strategy is a bit different. With this approach we focus on paying off our highest interest rate loans first, while continuing to make the minimum payments on our other balances. Once the loan with the highest rate is paid, we move on to the next highest interest rate debt, and so on.
The goal with this approach is to minimize interest expense while we’re paying down the debt. As you knock off the higher interest rate loans, more of your payment is going towards paydown of principle, so your total balance is coming down faster and faster – like an Avalanche!
So, which method is best?
Both strategies do work, but let’s take a look at an example so we can get a better idea of the differences.
Two friends, Georgia and Jason, happen to have identical debt structures and a strong desire to pay them off so they can focus on saving and investing.
Georgia can’t wait to be free of these debts, as she thinks about them often and they’re weighing her down. She’s a little intimidated, though, as she starts focusing on paying them down. It seems like such a big challenge and will take a long time to complete. Georgia decides to go with the Snowball approach because she likes the idea of getting some quick wins early on, thinking this will help to keep her motivated.
Jason also can’t wait to be free of these debts so he can start investing his money. He’s ready to tackle this challenge, but since he’s super analytical, he thinks that not focusing on the highest interest rate loans first would just be crazy… he’s going with Avalanche.
Here’s what their debt structures look like, and how they’ll prioritize the paydown of their debts based on the approach they’ve chosen.
Also, note that Jason and Georgia have both been able to come up with an additional $300/month, from part-time or gig work, to put towards their debt paydown plans. They’ll each be putting a total of $601.62 to work on their plan each month.
As you can see, Jason is going to target the highest interest rate balance first (Avalanche). Since that happens to be the largest balance, Georgia is going to target that one last, and instead focus on the smaller $1,500 balance first (Snowball).
Here’s a summary table showing how the two strategies worked for Georgia and Jason.
Since Jason tackled the higher interest debt first he saved $238 in interest expense and he was able to payoff all his debts one month sooner than Georgia. Not a bad saving!
However, Georgia got the benefit of early momentum in reducing the number of debts she had to deal with. In fact, she was able to completely eliminate three of the four debts in just 13 months. That was very motivating and encouraged her to keep going.
Clearly both strategies work, so pick the one that feels right for you and stick with it!
Additional debt paydown tactics to consider
Paying more than the minimum payment is important!
In the example above, Georgia and Jason were both able to manage the minimum payments on their loan balances AND pay an additional $300 per month. If they didn’t have that extra $300/month available, it would have taken a lot longer to pay down their debts.
To illustrate this, I re-ran the paydown scenarios without the extra $300/month and here’s what it looks like.
Clearly it takes A LOT longer to paydown the debt without the extra cash helping out each month. And they ended up paying A LOT more in interest.
It might be surprising to see that the paydown period and interest paid were almost the same for both Snowball and Avalanche. But, without the additional $300 to target specific debt balances, the prioritization loses its impact. Makes sense!
Accelerate paydown by taking on a gig or part-time job
Clearly having additional money available to put towards your debt paydown plan has a huge impact. Even if you’re working fulltime already, you might want to consider taking on a part-time job or driving for Lyft or Uber in your spare time to really accelerate you plan.
Keep your credit report clean
While you’re working on paying debts down, be sure to make at least the minimum payments on all loans and credit cards. If you miss payments, or are late, it will be reported to the credit bureau and will negatively affect your credit score. A damaged credit score can take a long time to repair and could prevent you from qualifying for a car loan or a mortgage in the future.
Debt consolidation
If you have loans at high interest rates, like on a credit card, you may want to investigate getting a consolidation loan. With a consolidation loan, your high interest credit card balances can be combined into one loan with a fixed repayment term
and a lower interest rate. Usually, the credit card account is then closed to avoid rebuilding that debt. There are pros and cons to consolidation loans, but they do offer the potential to save on interest.
You got this!
As we’ve said, spending less than you make and paying off debt (especially “bad debt”) are core aspects of growing wealth and achieving FI. Paying off whatever loans you may have might seem intimidating at first, but once you have a plan and are on your way, you’ll be amazed at how good it feels.
You might even be surprised at how quickly you achieve your goal. Good luck!