Paying Off Consumer Debt
As holiday decorations find their way back into storage, kids head back to school, and the days finally become longer, we hear people discussing their New Year’s resolutions. For some, that’s exercising more, spending more time with loved ones, or discovering a new hobby. In finance, a common resolution involves getting out of personal debt. There are two often-used approaches to accomplish this very commendable task: the debt avalanche method and the debt snowball method. Let’s say a consumer has each of the following debts (mortgage is not included in this exercise):
- $8,000 car loan at 5% interest rate, $250 minimum monthly payment
- $20,000 credit card debts at 18% interest rate, $500 minimum monthly payment
- $15,000 student loan debt at 6%, $250 minimum monthly payment
Debt Avalanche: Targeting the Highest Interest Rate
Using the debt avalanche method, the consumer’s objective is to pay off the loan with the highest interest rate first, which, in this example, is the credit card debt. If our hypothetical consumer had $5,000 each month to assign to this goal, they could make the minimum payments on their car and student loans and put the rest of the cash toward their credit card debt. Once the credit card is paid off, make the minimum payment on the car loan and put the rest of the cash toward the loan with the next highest interest rate, which is the student loan. This would eliminate all debts in a nine-month timeframe. The total paid would be $44,603, of which $1,603 would be interest payments.
Debt Snowball: Targeting the Smallest Debt
With the debt snowball method, the objective is also to eliminate all debts, starting with paying off the one with the smallest balance while making the minimum required payments on all others. In our example, the consumer would target the car loan first. Using the same monthly $5,000, the car loan would be paid off in two months and the remainder of the debts would be eliminated in 10 months. This would cost $45,394, including $2,394 in interest payments.
And for Educational Purposes Only: Making Nothing but Minimum Payments
In this method, the consumer makes only the minimum payments. All debts would take about five years to pay off and cost a total of $57,213, including $14,213 in interest. Far from an ideal scenario.
Most everyone can agree that keeping debt to a minimum, or getting out of debt entirely, is part of any sound financial plan. However, it is debatable as to which accelerated debt payment method is most effective. The debt avalanche method removes the most expensive debt first, which is often credit card debt, but it can be a slow process, which can be frustrating, making the consumer feel as if they aren’t making any progress. With the snowball method, the biggest advantage is psychological: After paying off the smallest debt quickly, the consumer may feel a sense of momentum. But it’s often more expensive overall because the consumer incurs more interest and can take longer to become debt-free.
Which of these methods would work better for you? In our example, the debt avalanche method is more cost efficient, but some people might take issue with delaying the car loan payoff. The truth about consumers is that we’re all different. Many of us set out to have high credit scores; pay for big-ticket items, such as a car or a boat, without taking out a loan; and free up funds to invest for retirement — all of which are rewards for paying off debt. Much depends on your discipline and ability to stick to a sound financial plan. Reach out to Team Savant at any time to discuss your financial goals. Happy New Year!
The examples above are intended for illustrative purposes only.
Savant Wealth Management (“Savant”) is an SEC registered investment adviser headquartered in Rockford, Illinois. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. The scope of the services to be provided depends upon the needs of the client and the terms of the engagement.