There are two generally accepted routes to paying down debts. The first focuses on the highest interest rate first and will cost you the least in interest over time if you are able to stick to it, and the second focuses on early wins by repaying small debts to snowball into larger successes.
In both cases you should make the minimum payments on all of your debts before choosing which method to devote extra money to.
Method 1: Debt avalanche
This method focuses on the most expensive debts first.
In the following example, there is sufficient spare budget to repay a total of £800 a month
- Credit card A: £2,000 with a minimum payment of £100/month, 10% interest
- Credit card B: £3,000 with a minimum payment of £300/month, 20% interest
- Personal loan C: £1,500 with a payment of £200/month, 4% interest
Using the debt avalanche method, you would maintain all repayments (£600 per month) and focus the additional £200 per month on credit card B, then credit card A, then the personal loan
It would take 9 months to repay all debts, and you would pay a total of £247 in interest over the term. (numbers taken from The snowball method calculator)
Method 2: Debt snowball
This method was popularised by Dave Ramsay, who has the following to say:
The debt snowball works because it’s all about behavior modification, not math. When it all boils down, hope has more to do with this equation than math ever will.
If you start paying on the student loan first because it’s the largest debt, you won’t get rid of it for a while. You’ll see numbers going down on the balance, but pretty soon you’ll lose steam and stop paying extra. Why? Because it’s taking forever to get a win! And you’ll still have all your other small, annoying debts hanging around too.Dave Ramsay – How the snowball method works
Taking the above example, but using the snowball method, you would repay personal loan C, then credit card A, then credit card B. Overall you would pay £63 more interest than the avalanche method, but you would have quick early wins (like building a small emergency fund before repaying debts).
Which method is best?
The avalanche method will both be quicker and result in paying less interest, but only if you stay the course! If you think that the psychological boost from paying off a smaller debt sooner will help you stay the course, do it! You can always switch things up later.
The important thing is to start paying your debts as soon as you can, and to keep paying them until they’re gone.
Should I be in a hurry to pay off lower interest loans? What rate is “low” enough to where I should just pay the minimum?
Depending on your attitude towards debt, you may want to stop paying off loans with low interest rates once you have paid all other loans above that threshold. A common argument is that the long-term return from investments in the stock market will likely exceed the interest rate from a low-interest loan. While this has been true in the past, keep in mind that paying down a loan is a guaranteed return at the loan’s interest rate. Stock performance is anything but guaranteed. Fairly common consensus is that loans above 4% interest should be paid off early in the debt reduction phase, while anything under that can be stretched out.
A caveat here is that repaying loans and credit cards is essentially a tax-free return. The repayment of a 4% APR loan by a basic-rate taxpayer is the equivalent to receiving (4%/0.8) = 5% on a taxable savings account. The effect is increased for higher-rate taxpayers.
Shouldn’t I stretch out a loan to improve my credit score?
No. Loans should never be stretched out longer than they need to be, as you should not pay a penny in interest more than you have to for the sake of improving one’s credit score. Interest rate should be the sole factor in whether you pay extra on a loan or not.
To plan debt repayments: The snowball method calculator
If debt is getting you down, or you feel you have a debt problem, seek expert advice from Stepchange, who are the largest debt charity in the UK.
Their website is https://www.stepchange.org/ and you can call them on 0800 138 1111