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Strategies for paying off debt: Avalanche or Snowball?

As we enter into the year 2020, optimistic and filled with hope, it’s a good idea to work out how to tackle your New Year’s Resolutions.

FINANCIAL FREEDOM – two simple words that describe what so many of us would ultimately love to achieve. A big part of achieving this goal is paying off your debt, as interest charges reduce the amount that you could be saving instead of using it to service your debt.

According to the Household Income and Wealth, Australia, 2015-16 report released by the Australian Bureau of Statistics (ABS), 29% of households in Australia were found to be overindebted and 77% of these households lacked sufficient liquid assets to cover a quarter of the value of their debts. Liquid assets are assets which can be easily converted to cash and include bank accounts, shares, own businesses, and superannuation (age permitting). The lack of sufficient liquid assets exposes overindebted households to the risk of defaulting on their loans if their incomes are not sufficient to meet repayments.

Rising property prices, declining interest rates and easier access to consumer credit has resulted in Australian households growing more comfortable with debt. However, high levels of debt, when considered against the value of current household income and assets, creates vulnerability in the event of an economic shock, such as increases to interest rates, the loss of a job, illness or injury, a change in family circumstances or a drop in asset prices.

Having a plan is essential to paying off your debt, so we will cover two strategies you can consider when deciding how to pay off your debt, namely the debt avalanche and the debt snowball strategies. There’s a case for both strategies, but we favour the debt avalanche strategy in terms of being the most efficient use of your money.

Go big or go home: The debt avalanche strategy

An avalanche is defined as a massive quantity of something that comes suddenly such as snow, ice, earth or rocks that come loose and speed down a mountain.

If getting the most bang for your buck will motivate you, then this strategy will suit you.

The debt avalanche involves tackling the debt with the highest interest rate first so that you can reduce what you spend on servicing debt as quickly as possible. It may take longer to cross the debts off your list if the higher interest rates apply to the larger amounts, so you will need to keep yourself motivated by reminding yourself that you are reducing your interest payments in the longer term and therefore saving more money at the end of the day.

Start small and work your way up: The debt snowball strategy

Picture a small snowball being rolled down a slope – it picks up snow along the way down, becoming bigger and heavier as it rolls, gaining speed and momentum as the weight increases. The snowball effect is defined as a situation in which the results or consequences of an action grow at an increasingly faster rate over time.

If you prefer to be motivated by quicker wins at the beginning of the process, the snowball strategy might be the way to go.

The debt snowball involves starting with the smallest debt first and working your way up to the largest debt. As you cross debts off your list, it may motivate you to pay off your debts even faster as you gain momentum and celebrate each debt paid off. As you pay debts off, you will also have increasingly more money to pay off the larger debts.

Where do I begin?

Any strategy begins with working out your starting point, i.e. how much do you owe right now? This can be an exercise many people avoid like the plague (even household chores seem more attractive). It’s not fun to face the music and somehow actually putting it down on paper (or screen) makes it very real. It’s probably the idea of seeing the total debt amount at the bottom of the column that stops people in their tracks!

But think of it this way – the sooner you deal with it, the sooner you can stop worrying about it and the lighter you will feel.

Here’s the step-by-step instructions:

  1. Take out a piece of paper or open a new spreadsheet. If pen and paper is your preference, we suggest using sticky notes (one note per debt item), so you can easily rearrange them into the order in which you want to pay off your debts.
  2. Add the following column headings:
    Description of debt, Interest rate, Total amount owing.
  3. List all your debts in the table.
  4. Decide whether you want to follow the debt avalanche or debt snowball strategy.
  5. Depending on which strategy you choose, sort your debts into the order you want to start paying them off. For debt avalanche sort by interest rate from largest to smallest, and for debt snowball sort by total amount owing from smallest to largest.  The amount at the top of the sorted list will be your very first target debt.
  6. Work out your monthly budget (which is a whole new article of its own) and allocate an amount to debt elimination (or obliteration which sounds even better). This amount should be more than the total of all the minimum amounts payable on your debts. If it is not, see where else you can cut your budget so you can allocate more to debt elimination.
  7. Always pay the minimum amount payable on all your debts so you don’t fall into arrears, except for the target debt you have at the top of your list. Once you have paid the minimum amounts, plough whatever is left into paying off your target debt item.
  8. Once you have paid off the debt at the top of your list, do a happy dance and move on to the next one on the list. Keep note of what you have paid off so you can refer back to it when your motivation is waning. We know you can do it!

Although the debt avalanche strategy yields the best results in monetary terms, it’s important to choose the strategy that motivates you to pay off your debt in as short a time as possible. The bottom line is that you should choose the strategy you know you can stick with until you are debt free.

At FutureNow Finance, we can help you to structure your debt so that it is easily manageable. Contact us today if you’d like to discuss your options. Call 1300 013 730 or email hello@futurenowfinance.com.au.

If you know of anyone who needs help paying off their debts, please share this article with them. You could help them fulfil one of their New Year’s resolutions for 2020!