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A Debt Winter Wonderland

February 3, 2017 by Bautis Financial

(By: Matthew DePompeo)
Debt is something incurred by many households in America. There are many different types of debt. Some of the most common debts are credit card debts, mortgages, Student loans, and auto loans. Some other less common debts can be personal loans and medical debts. Some debt would be classified as “good debt” and some you could call “bad debt”.
chart debt 1Credit Card debt is one of the most common ways to accumulate debt and one that usually would be called “bad debt”.
Debts can easily spiral out of control if you don’t track and plan payments. But don’t worry there are strategies to get back on track regain control of your debts. There are three useful strategies that you can use to help reduce your debts. These are called Debt Avalanche, Debt Snowball, and Debt Snowflake.
Each have their own purpose in reducing debts. Debt Avalanche is when you prioritize paying off the debts with the highest interests first. This allows for you to pay less interest and spend less time paying back a loan. After reading that you might ask yourself if I save more money and pay back the debts quicker then why would I want to use any other debt reduction strategy.
Another strategy is called Debt Snowball. Where the debt avalanche strategy went after the higher interest rate debts first the debt snowball goes after the small debt sizes first. This allows you clear debts off your plate and can give sense that you are actually making progress quickly. You can look at it as an emotional boost. If the savings is drastically different then sometimes the emotional boost may not be worth it. This is when you need to calculate using the two strategies to figure out which is more worth it.
There is a third strategy called Debt Snowflake. This Is when you pay a lot of little payments towards a debt. This is a method that can be used to make someone with a large debt feel they are making more progress in reducing their debt. As an example, with a large mortgage payment, one might feel overwhelmed, but by paying many small payment toward the mortgage you can feel like you are making progress and have that emotional boost.
Now that you have learned about these three techniques, we should compare them to show some of the differences. Something that should be noted is that outcomes can vary widely depending on your balance and interest rate per card. Looking at examples below there some assumptions that must be taken to correctly be able to show the comparison. The Debt balance, interest rates and Minimum payment (this is not the same as minimum credit card payments.) must be the same in each example.
In the example we’ll look at a a person who has a couple of credit cards, an auto and student loan.
chart debt 2
In this Scenario total minimum monthly payments for all of debt is 1,162. The total amount that the person is able to pay towards these debts is 1400.
That is an extra $238 ($1400-$1162) per month that we can use to pay down the debts. The entire $238 should go towards paying Credit Card 1 because that one has the highest interest rate. When you are done paying off credit card 1 the extra amount should go towards paying the 2nd highest interest rate and so on until all of the debt is paid off.

chart debt 3
With the Debt snowball the same principle is applied except you start with and continue with the smallest balance first. In this case you would use the extra $238 per month to pay off the student loan because that one has the smallest balance. Once that is paid off you would move on to Credit Card 1

If you compare them both you can see you will save about $1,239 in payments and about one months’ time to pay off the debt by using the Avalanche method. In this case you can see how the debt avalanche makes more sense, With that being said each scenario is different and should be decided on a case by case basis. The best way to have success with paying down debt is to plan out a schedule and stay disciplined with it until it is paid off.

Category: Budgeting/Saving, Personal Finance, Wealth Management
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