This week, we close on debt management with an example of two specific methods on how to pay off your debt, using the Snowball method or the Avalanche method.
These are the two-common debt-paying-off approaches. The debt snowball approach comprises listing all your debt in the order of lowest to the highest value, in terms of the balance outstanding to date, while the debt avalanche approach does not
necessarily consider the value of the debt but the value of interest, which means you list your debt in order of the highest interest-bearing debt to the lowest-bearing debt.
As we know interest rate has an impact on how soon one can settle or
pay off debt. With the Snowball approach, you make sure to pay all your debt but with the main emphasis on the first one, with an option to perhaps increase or double the instalment,
while paying the minimum on the
rest. Once you are done with the first debt and you have closed it off, you use that instalment to add on the next debt in line, ultimately increasing its instalment again, so you continue until you have paid off all your debt.
With the avalanche approach, you pay the debt with the highest interest first as a priority, but the principle of increasing or doubling the instalment on the first debt in line and then
taking that instalment balance to the second debt in line until you are done is similar to the snowball methodology.
Always pay extra on the first debt in line and continue down until you are done.
Below is an example of how it works in real terms. Let’s assume you have the following debts:
Agri Loan: N$70 000 (6% interest rate)
Credit Card: N$5 000 (19% interest rate)
Personal Loan: N$10 000 (17% interest rate)
Car Loan: N$90 000 (11% interest rate)
Mortgage: N$800 000 (12% interest rate)
The Debt Snowball Method will list a debt in the below order:
Step 1: Pay off Credit Card (N$5 000)
Step 2: Pay off Personal Loan (N$10 000)
Step 3: Pay off Agri Loan (N$70 000)
Step 4: Pay off Car Loan (N$90 000)
Step 5: Pay off Mortgage (N$800 000)
While the Debt Avalanche Method will list a debt in the below order.
Step 1: Pay off Credit Card: N$5 000 (19% interest rate)
Step 2: Personal Loan: N$10 000 (17% interest rate)
Step 3: Pay off Mortgage: N$800 000 (12% interest rate)
Step 4: Pay off Car Loan: N$90 000 (11% interest rate)
Step 5: Pay off Agri Loan: N$70 000 (6% interest rate)
The choice of which approach between the debt snowball and debt avalanche depends on you and your financial state and perhaps what makes more sense for you. What is important to note is that the debt snowball approach may provide you with psychological motivation, as you gain small wins when you settle your small accounts. On the other hand, the debt avalanche approach may save you more money over time in interest payments.
Disclaimer: These are just exemplary numbers, your debt details may look different but ensure that you understand the interest rate and balances outstanding on your debt monthly, as this obviously changes.
* Mekupi Kambatuku is the managing consultant at Simpli Business Advisory