All this talk about creating a debt payment plan…give me an example! Well, there’s no one right way to pay down debt. It depends on the type of debt you have, the amount of money you have available to pay down your debt, and, honestly, the type of person you are.
Fidelity identifies two common methods of debt repayment—the debt avalanche method and the debt snowball method.
- The debt avalanche method focuses on paying off higher-interest debt first to bring down the debt on which you owe the most interest. If you have a credit card balance with an interest rate of 20%, a student loan with an interest rate of 8%, and a car loan with an interest rate of 2.5%, after making minimum payments on all of those debts, you would allocate any extra funds to the 20% interest credit card because it costs the most in interest. This method of paying down debt is right for you if you have large balances on high-interest loans or credit cards and if saving money is a top priority for you.
- The debt snowball method focuses on paying off the smallest debt first, regardless of interest rate, so you can have a loan completely paid off, giving you a psychological boost. The snowball method addresses the emotional aspect of debt repayment. If you have a credit card balance of $500, a student loan of $8000, and car loan balance of $20,000, the snowball method would direct you to pay off the credit card balance and then move on to the student loan and then the car, so you can completely eliminate one source of debt entirely. The snowball method is good for those who have many sources of debt, and those who like accomplishing goals.