One of the key components of any financial plan is debt management. Poor debt management can derail the soundest of financial plans.
I was recently visiting with an individual who was paying additional principal to a loan that had the lowest balance as well as the lowest interest rate, collateralized with an asset that is appreciating as well as producing income, and tax deductions. It prompted me to ask some questions. The individual simply stated that he had not really considered the interest rate, or the underlying assets he was just focused on the loan with the lowest balance so he could knock one out entirely. My client is a snowball!
It made me think about how I typically address debt conversations, I have always stuck to math as opposed to how debt might make someone feel. I typically focus on the loan with the highest interest rate, along with consideration of the underlying asset. For instance, a car loan with higher interest rates on an asset that typically depreciates may be the better place to focus. I am an Avalanche!
Here is how it works:
Snowball Method
- Starts with the smallest loan
- Put extra payments toward the smallest balance until it is paid off
- Then move to the next smallest loan, pay the minimum plus the amount you were paying on the first loan.
- Keep going until all your debts are paid off.
- Benefit: Helps build momentum and it feels good to see zero balances.
Avalanche Method
- Starts with the highest interest rate
- Put extra payments toward the loan with the highest interest rate until it is paid off
- Then move the loan with the next highest rate. Pay the minimum plus the amount you were paying on the first loan.
- Keep going until all your debts are paid off.
- Benefit: May save the most on interest, especially if your loans have a wide range of rates.
The snowball method typically does not save as much interest as the avalanche method because it does not pay down the higher rates as quickly, but for many the clearing off the smaller debts creates some zero balances and feels like faster progress.
In all cases it makes sense to do math to see which method could work best for your situation. Also take time to review any potential fees or penalties for early pre-payments.
Obviously eliminating debt feels great! It also frees up cash flow to focus on other financial goals. Use the freed-up payment to build up an emergency fund containing 3 to 6 months of essential expenses to help avoid accumulation debt in the future. Then add to a savings for the next big purchase such as being able to purchase the next car with less or no debt. Then use excess to increase contributions to retirement or investment plans.
Category: Wealth Planning
