One of the earliest milestones on your financial journey is the point at which you become debt free. Of course, down the line it can certainly be beneficial to invest with debt capital (better to make money with someone else's money than your own), but that's a topic for another day. The last few decade or so has seen an environment of historic low interest rates and increased consumer behaviour, giving rise to a huge amount of discretionary consumer debt that will have to be paid off: in 2022 average EU household debt reached almost $7,000, and accounted for more than 50% of GDP.
In addition, the rise of tech-enabled BNPL (buy now, pay later) offerings like Klarna have reduced the barriers to discretionary (read: unnecessary) debt. It's now possible to buy shoes, holidays and even meals on finance! Given that it's never been easier to accrue debt then, it's also never been more important to understand how best to pay it off.
When it comes to paying down high yield debt, there are two popular methods: the avalanche method and the snowball method. Both of these methods have their pros and cons, and which one you choose depends on your personal situation. In this blog post, we will discuss the avalanche method and the snowball method in detail, so that you can decide which one is right for you!
What is high interest debt and why should you pay it down?
One of the first stages in our emergency finance guide (HERE), after living expenses is to pay down high interest debt. Typically this includes anything at over 10% APR but we actually think that things in the 6-8% qualify too. At this sort of rate, the level at which your debt is increasing each year has surpassed that of a typical year of stock market returns, meaning that even with a robust investment portfolio, your debt is likely growing faster than your investments!
The snowball method
Simply put, the snowball method involves paying off your loans in size order, starting wit the smallest. Once the first is paid, you take the cash flow that has now been freed up and put that to work on the next one. This should continue until all the debts paid off, with the amount you pay each month "snowballing" as more and more cash flow is freed up. As such, the rate at which the debt gets paid off increases the longer you stick with it.
The avalanche method
In contrast, the avalanche method prioritises the loans with the highest interest rates first. In the same way as before, as any cash flow gets freed up from the first loan, this gets rolled into the next tier until all your debt is clear, with the acceleration of the debt growth reducing as the total interest rate falls over time. By focusing first on the loans that are the most expensive to hold, you will be paying the least in total with this method.
How to decide which method is right for you
All being equal, you will most certainly pay less with the avalanche method: the fastest way to get debt-free is to pay your loans off in order of interest rate starting with the largest. However, if the principal is large, you may find that this method takes a long time to reach milestones and can be difficult to stick to. The best way of paying off all your debt is the way which gets done! So if you're the sort of person who has historically struggled with the discipline to pay your loans of in a timely fashion, the initial momentum from paying the smaller ones off may help you to stick to the plan. By tracking your loans on a debt paydown spreadsheet or on your Strabo dashboard, it may help you to see the progress you're making and keep motivation.
Another potential option would be to consolidate your debt into one place. It is possible to refinance loans, especially credit card debt, and there are services that offer debt consolidation loans (although it's a bitter pill to swallow taking out more debt to sort out the existing!)
So in short, the quickest and most efficient way of paying your debt down as quickly as possible is the avalanche method, or in order of high to low yield. If you are fully intent on following through with this, that's the way to go.
Finally, do make sure that you follow the order of our personal finance guide (HERE). Pay off essential and work related bills and build up a small emergency fund (1-3 months before high yield debt) to make sure that you will be ok in the case of any unexpected costs or bills that may set you back on your path to a debt free life! Finally, consider managing this process end-to-end through Strabo. A holistic dashboard for your financial life can reduce stress and remove the largest piece of friction to healthy finances, which is knowing exactly what's going on everywhere at any one time simultaneously. Check it out and sign up at the foot of the page!