How to Pay off Debt

Brendan Harkness

Brendan Harkness

Updated Sep 13, 2016

Two Methods to Pay Off Debt

There are two basic strategies for paying off debt that will work for most people: the snowball method and the avalanche method.

Each method requires you to pay the minimum payment each month on all of your debts, except one. For that other account, you’ll pay as much as you can each month. The difference is in the order you’ll pay your accounts off.

There are a few pros and cons for both of these methods, but one of them will probably work well for you. Take a moment to learn about each method, and the right one might seem immediately obvious.

The debt snowball and avalanche are both strategies for dealing with multiple debts. If you only have one debt that you’re serious about getting rid of, your strategy is simple: just make monthly payments as large as you can handle until the debt is gone.

These are methods for paying off the debt you owe, simply by paying down your accounts responsibly. There are also other options that can have a significant negative impact on your credit history, like declaring bankruptcy or settling debts in collections.

Having a solid debt strategy is like having a roadmap to being debt-free. Even if you face what seems like an overwhelming amount of debt, finding a good method and sticking to it gives you a way to consistently make progress.

The Debt Snowball Method

With the debt snowball, you’ll pay off your debts in order from the smallest balance to the largest. This is a good method to get you started paying down a fairly large amount of debt, giving you smaller successes towards the beginning that can help motivate you.

There are only two simple rules:

  1. Make the minimum payment on all of your accounts, but pay as much as you can each month toward the account with the smallest balance.
  2. Once that small account is paid off, move on to the next smallest and add in what you were paying towards that paid-off account. Continue like that until all of your debts are paid.

So, every time you finish paying off a balance you can add that monthly payment you were making to the next account. Every account you finish makes it easier to close out the next one.

It’s a bit like a snowball growing by rolling it on the ground: as it gets bigger, it can pick up more and more snow.  And with this method as you pay off one debt, it gets easier to pay off the next debt.

Debt Snowball Example

Say you have four different debts:

Type of Debt Balance Interest Rate (APR)
Auto Loan $15,000 4.5%
Credit Card $7,000 22.0%
Student Loan $25,000 5.5%
Personal Loan $5,000 10.0%

To use the debt snowball method:

  • Always pay the monthly minimum required payment for each account.
  • Put any extra funds you can spare towards the smallest balance, the personal loan.
  • Once the personal loan is paid off, take the money you were putting towards it and and it to your payments for the next smallest balance: the credit card debt.
  • Once the credit card is paid off, take what you’ve been paying and add it to your payments for the auto loan.
  • Once the auto loan is paid off, take what you’ve been paying and add it to your payments for the student loan.

So, you’ll end up paying off your accounts in this order:

  1. Personal Loan ($5,000)
  2. Credit Card ($7,000)
  3. Auto Loan ($15,000)
  4. Student Loan ($25,000)

Debt Snowball Pros and Cons

The debt snowball is generally good if you have a large number of small accounts to deal with. This method is better for people who have a hard time getting motivated to pay off a lot of debt.

If you’re facing an overwhelming amount of money to pay back, this method helps you see some progress as quickly as possible. You’ll get rid of the smallest, easiest balance first, and you can get that account off your bills and out of your mind.

It will be a little harder to pay off the next account, but you’ll always be able to add your payments from the previously zeroed accounts towards it. So you’ll be happy to see the end of that account, and you can also make larger monthly payments towards the next one.

The main downside to the snowball method is that you can end up paying more over time. Since you don’t order your accounts by interest rate, you could have a high balance at a high interest rate that you’ll end up paying off last. That account would generate a lot of interest, making this strategy potentially more costly than the next one.

The Debt Avalanche Method

With the debt avalanche method you’ll pay off your accounts in order from the highest interest rate to the least. 

Like the debt snowball, there are only two basic rules:

  1. Make the minimum payment on all of your accounts, but pay as much as you can each month toward the account with the highest interest rate.
  2. Once that account is paid off, move on to the next highest interest rate and add in what you were paying towards that paid-off account. Continue like that until all of your debts are paid.

Every time you pay off an account, you’ll have more money to put towards the next one. Since you’re tackling your debts in order of interest rate, you’ll pay less money overall and be out of debt more quickly.

It might take some time to finish paying off the first account if it’s large, but once you do you’ll start seeing progress. Like an avalanche, it might take a while before you see anything happen. But eventually, after you gain some momentum, your debts will fall away more and more quickly.

Debt Avalanche Example

Let’s take the same accounts we used in the first example.

Type of Debt Balance Interest Rate (APR)
Auto Loan $15,000 4.5%
Credit Card $7,000 22.0%
Student Loan $25,000 5.5%
Personal Loan $5,000 10.0%

To use the debt avalanche method:

  • Always pay the monthly minimum required payment for each account.
  • Put any extra funds you can spare towards the account with the highest interest rate, the credit card.
  • Once the credit card debt is paid off, take the money you were putting towards it and add it to your payments for the next highest interest rate: the personal loan.
  • Once the personal loan is paid off, take what you’ve been paying and add it to your payments for the student loan.
  • Once the student loan is paid off, take what you’ve been paying and add it to your payments for the auto loan.

So, you’ll end up paying off your accounts in this order:

  1. Credit Card ($7,000)
  2. Personal Loan ($5,000)
  3. Student Loan ($15,000)
  4. Auto Loan ($25,000)

Debt Avalanche Pros and Cons

The debt avalanche will help you pay less money in interest compared to the snowball method. It will also get you out of debt more quickly.

Like the debt snowball, every time you pay off an account you’ll have more money to put towards your next account. You’ll also have the satisfaction of seeing those high interest rates go away.

The only real downside to this method is that you’re not starting with the smallest balance, so it will generally take longer to see some progress. If you’re counting on some small wins to get you motivated, this method may not be for you.

But if you want to pay as little interest as possible while getting out of debt, try the debt avalanche.

Other Debt Management Options

Balance Transfers

Many credit cards offer the option to transfer a balance over from another card or account. This isn’t a bad move as long as you do it responsibly, but why would you want to do this?

If you have an account with a very high interest rate, you can transfer that balance over to a card with a lower rate. You’ll then spend less in interest over time.

Many credit cards even offer a 0% introductory APR for balance transfers, giving you an opportunity to pay off your balance without incurring extra charges. If you’re looking for a good balance transfer deal, check out our picks for the Best Balance Transfer Credit Cards.

Q&A Video: What is a Balance Transfer Offer? Is it a Good Idea?

Personal Loan

The personal loan option is sometimes referred to as “borrowing from Peter to pay Paul.” Essentially what you’re doing is borrowing some amount of money from a bank and then using that money to pay off your credit cards or other debts.

You’re in the same amount of debt, and you owe that debt to someone else. So, the question is, why would you do that?

First off, a personal loan is an installment loan, which means you’ll have the same payment for some fixed period of time. You also may get a lower interest rate, saving you some money. You can often consolidate several debts into a single personal loan, reducing your monthly payments along with the interest.

Installment debt is less damaging to your credit than revolving debt (like a credit card), so this move is good for your credit overall. You should expect your credit score to go up soon after the credit card-to-personal loan conversion, and it could go up impressively. 

Debt Settlements

Debt settlement is a negotiation in which a creditor, like a credit card company or collection agency, agrees to accept a partial payment rather than the full balance. Debt settlement is also referred to as debt relief, and you may be eligible for it if you’ve undergone hardships like job loss, medical problems, or divorce.

If you have outstanding debts to pay and can make a large one-time lump sum payment, then settlement may be the right option for you. When you settle a debt you may have to pay taxes on the forgiven amount, but negotiating payoffs for 50% of the total debt or even considerably less is often possible.

Debt settlement may sound like a simple solution to your debt problems, but it’s not that easy and there are several risks involved. Having one or more outstanding debts is bad for your credit, especially if any of them go to collections.

Many companies offer debt settlement services, but you need to be on the lookout for scammers and exorbitant fees. Debt settlement companies may promise to help you get debt-free easily, but sometimes they engage in deceptive practices and fail to deliver.

Read more about debt settlement and learn what to watch out for at the FTC Consumer Information website.

Bankruptcy

Declaring bankruptcy can be devastating for your credit, but in some cases it might be the right move. If you have outstanding debts that you can’t pay off, bankruptcy can eventually give you a fresh start.

There are two types of personal bankruptcy that people can declare: Chapter 7 and Chapter 13. Chapter 7 bankruptcy often requires you to surrender some of your property, while Chapter 13 doesn’t.

Bankruptcy can be a long, expensive process that you shouldn’t take lightly. There are attorney fees to deal with, as well as court filing fees. You’ll also be required to get credit counseling before filing.

Learn more about bankruptcy from the FTC Consumer Information website.

Q&A Video: Is There Anything Worse Than Bankruptcy?

Revolving Debt vs. Installment Debt

There are two main types of debt that are important when it comes to your credit: revolving and installment. These types of debt are affected differently by interest rates, and they’ll have different effects on your credit.

Revolving debt comes from loans like credit cards, where you can choose to carry a balance from month to month if you’d like (this is called “revolving” a balance). The amount of money you can borrow is limited, but you can borrow as much as you’d like up to that limit. The interest rates are subject to change.

Installment debt comes from loans like mortgages, auto loans, student loans, and personal loans. The amount of money you borrow, the interest rate, and your monthly payments are fixed at the start.

How do Revolving and Installment Debt Affect Your Credit?

Your credit score is calculated based on a variety of factors, including the presence of revolving and installment loans. There are ways that these loans can help your credit, and there are other ways they can hurt it.

It’s good to have a variety of account types on your credit report, because this shows that you can manage different types of loans effectively (assuming you’ve been paying them off on time).

When it comes to installment loans, having a high balance won’t have a very negative affect on your credit. This is why student loans and mortgages don’t ruin your credit.

Revolving loans, on the other hand, are a different matter. Carrying a high balance on your credit cards from month to month will have a negative affect on your credit, especially if you’re doing this with multiple cards.

The main area this will hurt you is when it comes to your credit utilization, which carries a lot of weight when calculating your credit score. To keep your score up, it’s best to keep your balances as low as possible on your credit cards – preferably paid off entirely by the end of the month.

But remember that paying late on any loans, revolving or installment, will have a negative effect on your credit score.

Paying off Revolving Debt with Installment Debt

If you can afford to simply pay off your credit card debts, that’s obviously the best and easiest strategy. But if you can’t do that, it is possible to improve your credit by paying off some revolving loans using an installment loan.

Installment loans don’t hurt your credit the same way that revolving loans do, so if you can pay off your credit cards by getting an installment loan that would improve your credit.

Taking out another loan to pay off your credit cards can be a dangerous strategy. If you have a history of using credit irresponsibly, this may not be a smart move.

If you do take this strategy, remember these three key points:

  1. Don’t close the credit cards that you pay off; keeping them open will help your credit utilization.
  2. Consider your paid-off credit cards to be off-limits. Don’t take these cards as permission to get back into debt.
  3. Pay off your installment loan on time. If you don’t, you’ll just be making more problems for your credit.
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