After making your budget, you should have an accurate idea of how much money you have for debt repayment each month. The next question is how best to use it.
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 debts with the highest interest rates first.
In the following example, there is sufficient income 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 minimum 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 where a debt gets removed from your list.
Which method should I use? ⚖️
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? 🏃
Depending on your attitude towards debt, you may want to pay only the minimum payments on debts with low interest rates. 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 as early as possible, while anything under that can potentially be stretched out in order to prioritise investments.
Should I pay off my student loan? 🎓
We are lucky in the UK that most higher education costs are provided by way of subsidised loans. It may seem like common sense to want to repay these loans as quickly as possible, but in reality the cost is usually much lower. Money Saving Expert has an in-depth guide about this which is essential reading for anybody looking at the costs of undergraduate study.
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. More about credit ratings.
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.
MSE’s debt help page: https://www.moneysavingexpert.com/loans/debt-help-plan/