Crush your debt

When debt is left unchecked, it can quickly spiral out of control. What may seem like innocent purchases can become suffocating over time. In Australia, thirty eight per cent of people are swimming in credit card debt, and an astonishing twenty two per cent of young Australians are battling buy-now-pay-later debt. On average, Australians carry over $two hundred thousand dollars in debt at any given moment.

To a large extent, our economy thrives on debt. Cars, houses, and even clothing are often financed in some way. Whether through a personal loan or a credit card, paying in cash has almost become unusual. If you walk into a car dealership and try to pay upfront, they will look at you like you have three heads. Of course there is good and bad debt but what happens when it all becomes too much? It’s natural to feel overwhelmed, but it’s crucial not to ignore the problem. You have options.

When managing debt, there are generally three widely accepted best practices. Each approach has its own strengths and weaknesses, and what works for one person may not be the best fit for another. The key is to choose the method that suits your situation best.

AVALANCHE:
The Avalanche method is an accelerated debt payoff strategy. It’s based on the principle that every dollar borrowed comes with a cost. That cost is represented by the interest rate. So each dollar borrowed at two per cent is cheaper than each borrowed at six per cent. The main idea behind the Avalanche method is to focus on paying off debts with the highest interest rates first, minimising the overall cost of borrowing.

First and foremost, all minimum repayments on your debts should be made. There’s no point making progress on one debt while falling behind on others, so with the Avalanche method, you start by paying the minimums on all debts. Once the minimum payments are covered, any spare funds should be used to make extra payments on the debt with the highest interest rate. This is because, dollar for dollar, the debt with the highest interest is the most expensive. The focus is on paying off the most costly borrowing first, which refers to the percentage interest rate, not the dollar amounts. For example, a debt with a twelve per cent interest rate should be paid off before one with a six per cent interest rate and so on. Once the highest interest loan is paid off, direct your extra funds to the next highest interest rate, and continue this process until you’re debt-free. As each debt is eliminated, you’ll free up more money to tackle the next one, accelerating your progress.

The advantages of the Avalanche method are clear. By targeting high-interest loans first, you lower your overall interest expenses and can potentially pay off debt faster. This is because the debt with the highest interest rate doesn’t get a chance to accrue as rapidly.

However, the downside of the Avalanche method is that it focuses on high interest rates rather than high balances. For example, a loan with a one per cent interest rate on ten thousand dollars would be left until a loan with a two per cent interest rate on a mere thousand dollars is paid off. While the ten thousand dollar loan costs more in total dollar terms, the one thousand dollar debt is technically more expensive due to its higher interest rate.

This concept can be tricky to grasp. The one thousand dollars costs more because each dollar is priced at two percent compared to one percent on the larger principled debt. However, even a small interest rate on a large balance can result in significant costs in actual dollar terms.

SNOWBALL:
The Snowball method is another popular strategy for getting out of debt. With this approach, you focus on paying off your smallest debts first, regardless of the interest rates. The goal is to gain momentum by eliminating smaller balances, which can provide a psychological boost as you work toward paying off the large debts.

After covering the minimum payments on all debts each month, any spare funds should be directed toward the smallest debt. If you had two debts of a thousand dollars and four thousand dollars, you would focus your extra funds towards paying off the thousand dollars when using the Snowball method. Once the smallest debt is fully paid, you redirect those extra funds to the next smallest debt. This process continues until you’re debt-free. As each debt is eliminated, your available funds will increase, since fewer minimum payments will be required, allowing you to pay down the remaining debts faster.

The Snowball method can be highly motivating, as you see each debt disappear. These small wins can be especially encouraging for beginners. Unlike the Avalanche method, the Snowball approach is straightforward and doesn’t require much financial literacy. There’s no need to compare interest rates or percentages making it easier to follow for those who prefer simplicity.
The downside of the Snowball method is that it may not save the most money in the long run. This is because it doesn’t account for larger balances or high-interest rates, which can continue to grow unchecked. As a result, larger debts with high interest will take longer to pay off and could end up costing more overall.

SAVINGS:
This approach is less formal but works best when used alongside the Snowball or Avalanche methods. Both of the previous methods mention using extra funds to pay off debts. Therein lies a problem. Many who are being crushed by their debt don’t have spare change to begin with. Creating a budget is one of the most effective ways to control overspending, yet many people either lack the time or the know-how to create one. Some hear the word budget and feel instantly trapped.

While creating a proper budget is ideal, many people can identify areas of overspending without the need for a complicated spreadsheet. Most of us know where we could cut back for a while. Simple actions like cancelling unused streaming services or meal prepping lunches for work can make a big difference, even in the short term.

The real key to success is using those newly found extra funds to make additional debt payments, rather than pocketing or wasting them. While this may feel like a temporary sacrifice, it will help you eliminate debt much faster, essentially accelerating the benefits of the Avalanche or Snowball methods. The discomfort is only short-term, and once your debt is gone, you might find that having extra money at your disposal is more satisfying than you expected.

Regardless of which method works best for you, it’s crucial to pay off bad debts. Beyond the risk of default or dealing with debt collectors, carrying significant consumer debt makes it difficult to build a stable financial future. The more debt you carry, the less disposable income you’ll have in the future. Each time you use credit, you’re essentially reducing the money available to you in the coming months.

It may seem obvious, but debt must be repaid. For example, let’s say your debt repayment is eighty dollars per week. At first glance, most people think they can manage that. If you reframe the situation and ask yourself, “Is this purchase worth earning eighty dollars less next week?” you might reconsider whether the debt is really worth it. The truth is, that eighty dollars isn’t yours anymore, you’ve already committed it to the credit card company. Instead, that money could be building an emergency fund to avoid panic when unexpected expenses arise, or it could be invested to secure your financial future. At minimum it could be put towards a holiday.

MORTGAGES:
This article focuses on methods for paying down consumer debt. The largest debt most people will have in their lifetime is a mortgage. However, including your mortgage in strategies like the Avalanche or Snowball method can derail the process, especially if the balance exceeds one hundred and twenty thousand dollars. Most mortgages in Australia are structured as thirty year terms, intentionally designed to take longer to pay off, allowing banks to profit more from the interest. While there are faster ways to pay off a mortgage, the Avalanche and Snowball methods are specifically tailored for consumer debts, not long-term mortgage repayments.

Generally speaking, one of the fastest ways to pay off your mortgage is to make more frequent, regular payments. The more often you pay, the faster the mortgage balance will decrease. This is because mortgage interest is typically calculated daily, but most people make payments just once a month, usually at the end of the month. Waiting the full thirty days allows interest to accrue for the entire month. In contrast, paying twice a month reduces the accrual period to about fifteen days, so more of your payment goes toward the principal, and less is lost to interest. While this approach can make budgeting more challenging, it can significantly reduce the length of your mortgage by decades on top of saving you hundreds of thousands of dollars in interest over time.