Last week I set out 5 steps for paying off debt faster, one of which is choosing the repayment strategy best suited to your situation. The execution of a repayment strategy can take months or even years. With the deeply emotional impact of money, it is essential that the strategy we choose to guide our finances over an extended period is effective in both monetary and emotional terms.
Simply making additional contributions according to the ratio of outstanding debt balances or paying an extra R200 to each account are not effective strategies. As with all other financial goals, a focused, clearly formulated plan is easier to achieve and maintain
1. Avalanche method
This strategy entails ranking debt from the highest interest rate to the lowest and paying off the most expensive debt first. Such debt usually consists of payday loans, unsecured credit, credit cards, store cards and personal loans. Because the interest rate is so high on these types of debt, a large part of the instalment goes towards interest instead of the principal loan amount. Paying up high interest rate debt before the end of the debt period can lead to a substantial saving. Even making only one or two additional payments will make a difference. Once a debt is paid off, redirect the instalment previously paid on that particular debt towards the next debt.
Mathematically the avalanche method of paying off debt is undoubtedly the most effective as it leads to long-term saving. As a
2. Snowball method
The only difference between the avalanche and snowball methods is the ranking used to determine which debt to pay off first. The snowball method ranks debt from the smallest balance to the largest. While this method is not quite as effective as the avalanche method in terms of saving on interest (a high interest rate debt could also be a high balance debt, meaning it could be lower down on the snowball list), it does have a significant emotional edge.
Seeing the number of accounts gradually decrease and the speed at which you manage to pay off an account increase as your “snowball amount” is redirected from one account to the next, provides tangible proof that you’re making headway. When you are overwhelmed by debt, these small victories hold great power. It motivates you in a way that the avalanche method does not necessarily do. For this reason, I personally prefer the snowball method. Getting out of debt is tedious and painful. We need to grab every ray of sunshine that crosses our debt-laden path.
3. Debt consolidation
If you function better having only a single, large account, consider consolidating the different accounts on one credit card or personal loan. This can be especially useful if you do not have extra money in your spending plan to make additional contributions to your debt, or if you have debt with very high interest rates. Restructuring debt in this way can lead to a single payment that is lower than the combined payments of the separate accounts. If that is the case, continue paying the same amount previously paid to the different accounts to the new combined account to pay it off quicker.
Bear in mind two things: 1) be sure to consider all the fees as initiation fees can erode a possible consolidation saving; 2) never consolidate short-term debt (credit cards, holidays, car loans, etc.) with an access bond on a home loan. The total interest payment alone on a home loan over 20 years is more than the initial capital amount of the loan. Such an interest payment is acceptable on a house as it is an asset that increases in value. Getting into a similar interest to capital ratio for living expenses is not a good idea.
4. Early settlement
You may wish to settle debt early if you unexpectedly receive a windfall. Some creditors offer a discount for early settlement, which makes this an appealing option. However, always consider the opportunity cost of not saving or investing this money. Depending on your debt and your circumstances, it might be better to direct the windfall elsewhere (not into shoes and clothes!).
Get in touch if you need assistance determining the debt repayment strategy best suited to your circumstances.