There are two techniques that have garnered the most attention: the Debt Snowball and the Debt Avalanche.
Debt snowballing is a debt repayment technique that involves paying off your smallest loans first. The idea behind this is that many people need a boost to encourage them along the way. When payment is tough and you lose sight of ever getting out of the red, that quick boost of paying off a small credit card balance or a utility bill keeps you going. Plus, once that small thing is paid off, you can transfer the payments you would have normally used for that to apply to your next smallest debt helping to repay that faster.
The debt avalanche supports paying off your highest interest rate first. The logic behind this method is that by paying off your highest rate, you will avoid paying extra interest. Lowering your interest payments means you can pay more on your second highest rate and so on until you are debt free. You will pay less interest overall and get out of debt faster than any other method.
I would also like to present an additional option that will surely be met with disdain from most of the debt-fighting population. Let me direct you to the stress impact method. I'm bolding that because I came up with it myself and am inordinately proud. The idea is a hybrid of two factors that I think are important. It involves pay off the debt that is causing you the most stress first and paying off what will make the biggest impact to your bottom line or your credit report. Let's look at these factors individually.
Stress factor. I would argue the merit of the debt snowball for one main reason - it has emotional impact that the debt avalanche misses. I know there is a battlefield with very vehement supporters of both who are always at odds. However, I would still argue the merit of this to most people in debt since the reason for it is 10 times more likely to be based on emotion rather than circumstance. Enter stress based debt reduction. The debt snowballs focuses on the smallest debt to get that first small win. I would suggest the largest stressor. I know people who have mounds of student loan debt that can make their minimum payments, but have one store credit card with a balance that keeps them awake at night. What about that car loan you shouldn't have taken out that makes you angry every time you think of it. Make it a goal to lower your stress, thereby increasing your motivation and determination to keep going by paying off the most emotionally impactful debt.
Impact factor. Which debts impact your financial well-being the most? For example, showing a history of on-time payments for a credit card, but being late for your mortgage shows up as a huge difference on your credit report. When times are tough, you always move back to your core which is shelter and utilities. How about the interest rate? If your car loan is at 2% while your credit card is 22%, that will also have a large impact depending on the balance of those accounts. To get ahead, you need to be mindful of how each debt affects you.
Put it into action. The first step is sitting down with a list of all your debts. That list needs to include what the debt is, what your monthly payments are, the total amount of debt, and the interest rates.
For this example, we have four accounts. Both the debt snowball and avalanche methods would attack the credit card first. This might be a great first move. You pay off the highest rate first while also giving yourself that kick to get you going. But let's consider a narrative:
In your mind, credit cards are used in emergencies. Last year when your car gave up the ghost in the middle of the road, you had to have it towed to a mechanic (which hurt) and have major engine surgery (which really hurt) before you could drive her again. You didn't have the money in your checking account so you paid on a card and are paying it off. That car gets you to and from work every day. It needs to be reliable so you can be too.
The store credit card was something you got so you could get 10% off the shopping spree you never meant to take while you were feeling down. You did some shopping therapy and are still paying for it a year later.Both of these situations caused a credit card balance. Now, if you have the will, pay off your normal credit card first. It will do you the most good and help you pay down your debt faster. However, if you really can't stand the store card, it won't leave you alone and you regret every payment, pay that off first. It will give you the motivation and fortitude you need to move on.
Once you've taken care of that, let's look at the student loan and car loan. They have the same balance and the same rate.
While in college, you had the opportunity to work your way through school. Instead of taking advantage of that, or scholarships, or living with roommates, you did not. Investing in yourself was a good decision. Using debt to pay it was not.
Your car finally died. After a few solid hours of mourning, you headed out to find the next one. Unable to buy it up front, you chose the best financing options available. Just like fixing your old one, having a car is a necessity and if you have to pay extra then so be it.Here's where you have to make a decision. What is more important to you? If that student loan is the thorn in your side, then maybe that should go first. But if you can hold off, paying your car loan will benefit you more. Student loan debt is seen as a positive investment from a credit standpoint and can increase your score or help start building credit if you are younger. Your car loan can do that as well, but doesn't count as much. In addition, your car loan cannot be deferred if you go back to school or lose your job. In this case, impact should take precedence if you can stand it.
I am a firm believer that the debt avalanche is the smartest way to go. It's got the numbers to back it up and I like anything that is highly logical. Yet, humans are no so. We make decisions largely based on emotion and that can trump good planning every time. Looking at debt as both a financial and psychological hurdle may muddy the waters, but it might just offer another way to view the path to financial freedom that works for you.