You need some quick wins in order to stay pumped enough to get out of debt completely. The debt snowball method's big advantage is that it helps build motivation. Because you see fast results—eliminating some outstanding balances completely in only a few months—it encourages you to stick with the plan.
That mountain of debt doesn't seem so unscalable after all. Plus, it's easy to implement—no need to compare interest rates or APRs; just look at each sum you owe. The big drawback of the debt snowball is that it can be more expensive overall. Because you're prioritizing balances over APRs, you could end up paying more money in interest. Getting completely free and clear could take more time, too, depending on the nature of the debts, and how frequently the interest on them compounds.
Both the snowball method and the avalanche method are types of accelerated debt repayment plans —ways of speeding up the retirement of your debts, by paying more than the minimum due on them each month. Of course, both assume you can afford to commit extra funds to pay down what you owe on a regular basis.
If your income is irregular or unstable—or if you think a layoff is imminent—you might want to stick with making minimum payments. If you're applying one of these strategies to credit card balances, they should be credit cards you don't plan to use for new purchases.
You can't pay off a balance, obviously, if you're continuously adding to it. Finally, there may be special circumstances with certain debts that alter your repayment schedule. Whatever debt repayment method you're using, however, you'd definitely want to clear this balance before the special introductory rate period ends—regardless of how it compares to your other bills. Otherwise, you'll just have added a fresh pile to your interest-rate-bearing obligations.
The debt snowball is a type of accelerated debt repayment plan. You list all of your debts from smallest to largest. You then devote extra money each month to paying off the smallest debt first; you make only minimum monthly payments on the others.
When the first balance is settled, you move on to the next smallest. The debt snowball can be an effective method for settling just about any type of debt, with the exception of mortgage loans.
A lot of its appeal is psychological. It has the debtor target small balances to pay off first; erasing these "easier" outstanding balances gives a motivational boost, encouraging the debtor to stay disciplined and keep on with their debt repayments—the way the quick loss of a few pounds encourages a dieter to stay with a weight-loss program. Whether a debt snowball or a debt avalanche is better depends on whether we're speaking in financial or psychological terms.
In terms of saving money, a debt avalanche is preferable. Since it has you pay off debts based on their interest rates—targeting the most expensive ones first—it means you end up paying less in interest. That adds up to paying less money overall—provided you stick with the payment plan. But, as any behavioral finance expert will tell you, human beings are often irrational when it comes to money. They find it much easier to stay motivated when they pay off smaller debts first, regardless of their interest rates.
So, even though it might cost more, the debt snowball is better, psychologically speaking—debtors are more likely to stick with the program because they have a stronger sense of making progress. Whether you should pay off big debt or small debt first depends on your psychological makeup. Studies have shown that paying off small debts often leaves people feeling more satisfied—small victories, so to speak—and more likely to keep on with a repayment program that eventually clears all their outstanding balances.
Certainly, you get quicker results paying off the small debt, and it simplifies life, to have fewer bills coming in each month. On the other hand, paying off big debt is more cost-efficient in the long run.
The larger your outstanding balance, the more interest it's generating; in fact, a big percentage of your monthly minimum payment is probably going just towards the interest. So, by settling the big debt, you will save on interest, and you will free up funds for other bills and other purposes.
Paying off debt has its advantages—especially if you're incurring a high-interest rate on it. With a lot of consumer debt like credit cards , as much as half of the monthly minimum payments go towards interest.
Those interest payments are just money thrown away. A lot of debt will also ding your credit score, making it hard to get financing at good rates if you want to buy a home or other big-ticket item. And finally, paying off debt will free up funds for other things—like savings or investments. But there are pluses to saving too. You're putting your money to work for you, generating returns and earning interest.
And, thanks to the miracle of compounding , your principal can multiply quite a lot over the years. Since time is a factor, the earlier you start, the better. Of course, much depends on what prevailing interest rates are, and how aggressively you want to invest your funds. As a general rule, if you can earn more interest on your money by investing it than your debts are costing you, it makes sense to invest.
If you are serious about tackling your debt, then pick which method is best for your own situation and personality. The best method is the one you can stick to. If you are a person that needs more incentive to pay off debt, then stick with the debt snowball method.
If devoting money to interest payments—instead of denting principal—drives you nuts, then you might prefer the debt avalanche approach. You can also use a combination of the two methods. The highest interest rate debt might not be the smallest balance owed, and so using this method can seem like marathon instead of a sprint.
The snowball method is better for people who want to see progress quickly, celebrate small wins and use that momentum to tackle larger debt.
In this method, you start with the smallest balance first. Skip Navigation. Not all debt is the same. So how should you decide which to repay first? VIDEO Invest in You: Ready. It's like a feeling of drowning when it comes to consumer debt, the interest rates are so high.
Avalanche vs. These 6 financial strategies can help military members transition to civilian life. Michelle Fox. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. Debt is something, usually money, borrowed by one party from another. Debt is used by many corporations and individuals to make large purchases that they could not afford under normal circumstances.
A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest. The most common forms of debt are loans, including mortgages, auto loans, personal loans, and credit card debt. Under the terms of a loan, the borrower is required to repay the balance of the loan by a certain date, typically several years in the future. The terms of the loan also stipulate the amount of interest that the borrower is required to pay annually, expressed as a percentage of the loan amount.
Interest is used to ensure that the lender is compensated for taking on the risk of the loan while also encouraging the borrower to repay the loan quickly to limit his total interest expense. Credit card debt operates in the same way as a loan, except that the borrowed amount changes over time according to the borrower's need—up to a predetermined limit—and has a rolling, or open-ended, repayment date. Certain types of loans, including student loans and personal loans , can be consolidated.
There are four main categories of debt. Most debt can be classified as either secured debt, unsecured debt, revolving debt, or a mortgage. Secured debt is collateralized debt.
Debtees usually require the collateral to be property or assets with a large enough value to cover the amount of the debt.
Examples of collateral include vehicles, houses, boats, securities, and investments. These items are pledged as security and the agreement is created with a lien. Upon default, the collateral may be sold or liquidated, with the proceeds used to repay the loan. Like most classes of debt, secured debt often requires a vetting process to verify the creditworthiness of the borrower and their ability to pay.
In addition to the standard review of income and employment status, the ability to pay may include verifying the collateral and assessing its value. Unsecured debt is debt that does not require collateral as security. The creditworthiness and the debtor's ability to repay are reviewed before consideration is given. Since no collateral assignment is issued, the debtor's credit profile is the primary factor used in determining whether to approve or deny lending.
Examples of unsecured debt include unsecured credit cards, automobile loans, and student loans. How much is loaned is often based on the debtor's financial position, including how much they earn, how much liquid cash is available, and their employment status. Revolving debt is a line of credit or an amount that a borrower can continuously borrow from. In other words, the borrower may use funds up to a certain amount, pay it back, and borrow up to that amount again. The most common form of revolving debt is credit card debt.
The card issuer initiates the agreement by offering a line of credit to the borrower. As long as the borrower fulfills their obligations, the line of credit is available for as long as the account is active. With a favorable repayment history, the amount of revolving debt may increase.
A mortgage is a debt issued to purchase real estate, such as a house or condo. It is a form of secured debt as the subject real estate is used as collateral against the loan. However, mortgages are so unique that they deserve their own debt classification. There are different types of mortgage loans, including Federal Housing Administration FHA , conventional, rural development, and adjustable-rate mortgages ARMs , to name a few. In general, lenders use a baseline credit score for approval, and those minimum requirements may vary according to the type of mortgage.
Mortgages are most likely the largest debt, apart from student loans, that consumers will ever owe. Mortgages are usually amortized over long periods, such as 15 or 30 years. In addition to loans and credit card debt, companies that need to borrow funds have other debt options.
Bonds and commercial paper are common types of corporate debt that are not available to individuals. Bonds are a type of debt instrument that allows a company to generate funds by selling the promise of repayment to investors. Both individuals and institutional investment firms can purchase bonds, which typically carry a set interest, or coupon, rate. Bondholders are promised repayment of the face value of the bond at a certain date in the future, called the maturity date , in addition to the promise of regular interest payments throughout the intervening years.
Bonds work just like loans, except the company is the borrower, and the investors are the lenders, or creditors. In corporate finance, there is a lot of attention paid to the amount of debt a company has. A company that has a large amount of debt may not be able to make its interest payments if sales drop, putting the business in danger of bankruptcy.
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