A debt payoff plan that works
If you've got a mountain of debt, is it better to fight it with a snowball or an avalanche? The
cold truth is that 1 size doesn't fit all.
[Related content: budgeting, debt consolidation, bills, Liz Pulliam Weston, debt]
By Liz Pulliam Weston
If you want to stir up a hornet's nest among personal‐finance bloggers, declare that the
debt snowball is far superior to the debt avalanche, or vice versa.
Most people won't understand what the heck you're talking about, but passionate
adherents of either debt payoff method will spend hours honing their arguments and
Both approaches (which I'll explain in a minute) have their advantages and drawbacks, but
a fistfight over methods is the last thing you need when you're sinking deeper in debt. You
just want to know the best strategy for clawing your way out.
So here's the short version: Any method can work if you free up enough income and apply
it diligently to your debts. But if you want to craft the smartest payoff plan possible, you
shouldn't marry any single approach but instead create a plan that reflects your individual
situation and types of debt.
I have some ideas about how best to do that, but let's define some terms before we go
• Using the debt snowball approach, you order your debts by size and pay off the
smallest first, on the theory that quick wins will keep you motivated. You throw as
much money as possible at your chosen debt while paying the minimums on the
rest. When the targeted debt is gone, you apply the same payment plus the
minimum to the next debt, and so on. The amount you apply to your targeted debt
grows as you pay off each bill, and you pack together those little victories to make a
big dent in what you owe. This method is touted by personal‐finance guru Dave
Ramsey and his many enthusiastic followers.
• With the debt avalanche method, you pay off your debts by interest rate , tackling
the highest rates first. The term was popularized by blogger Flexo at Consumerism
Commentary, although the method has been applied for years by financial planners
and others. The avalanche is the mathematically superior approach because you will
pay less interest and can get out of debt quicker.
• A third method, the debt snowflake, can supplement the other strategies. When you
snowflake, you look for little ways to trim your expenses. Brown‐bagging it today? If
you were "snowflaking," you would apply the $10 you'd saved on lunch directly to
your debts, either the same day or at the end of the week (hopefully combined with
other little snowflakes of savings).
• Finally, because we're getting all chilly, I'll coin a new phrase: debt calving. A glacier
calves when a big chunk of ice shears off its face, typically landing in the water with
a big splash. Debt calving is when you get a big windfall and throw chunks of it at
Before you start freezing out your debts, though, you need to take a closer look at what you
owe and create a plan. Here's what you do:
List all of your debts
You need an inventory of everything you owe. Go through your bills and pull copies of your
credit reports (get free access annually at AnnualCreditReport.com) to make sure you don't
miss any accounts.
Don't forget to include:
• Credit cards. • Private student • Medical debt.
• Store cards. • Debt
• Mortgages. consolidation
• Gas cards. loans.
• Home equity loans
• Personal loans. or lines of credit. • Collection
• Retirement plan • Business loans.
loans. • Payday loans.
• Auto loans.
• Life insurance • Pawnshop loans.
loans. • Boat loans.
• Title loans.
• Federal student • Other vehicle
loans. loans. • Overdraft
For each debt, you'll need to note whom you owe, how much you owe, the current interest
rate and the minimum payment.
You can typically find the interest rate of a loan on your monthly statement or by calling
your lender to ask. Calculating interest rates for payday advances and overdraft balances is
tougher, but you can figure your annualized interest rate is in the triple digits, so these
should be at the top of your payoff list.
Negotiate for lower rates
Lower interest rates will help you get out of debt faster, so you want to check the
possibilities for getting better rates on each of your debts. Some ideas:
• Consider balance transfer offers, personal loans or peer‐to‐peer lending. You might
be able to get a better credit card interest rate using a balance transfer offer,
although you have to do the math. Fees for these offers usually increase the debt
you're transferring by 3% to 4%, so the interest rate break needs to be big enough
and last long enough to offset the fee.
• You can find offers at CardRatings.com, Bankrate.com and CreditCards.com. Also
check into personal loans from your bank or credit union or a loan from a peer‐to‐
peer site such as Prosper or Lending Club. The rates on these loans are typically
fixed, unlike credit cards rates, which can soar to 30% or more.
• Consolidate federal student loans and choose the longest possible repayment term.
Consolidation will fix your rate if it's variable and may allow you more than the
usual 10 years to pay off your balance. The more debt you have, the longer the
repayment term you can choose. (See "Consolidate your student loans now.")
Stretching your loans over 15, 20 or 30 years will lower your monthly payment for
this good debt so you can throw more money at your toxic debts. Once higher‐
priority debts are paid, you can speed up your student loan payments. If your job
qualifies, you may also be eligible for student loan forgiveness after 10 years.
• Use home equity or retirement plan loans with care. You may be able to lower your
interest rates by using these loans to pay off other debts, but you're also putting
your wealth at considerable risk. For more, read "The 3 worst money moves you can
Categorize your debts
Divide your debts into "good," "neutral" and "toxic" piles. There are those who believe
there's no such thing as good debt, but financial planners know that certain obligations
can help you get ahead.
A reasonable amount of mortgage debt, for example, will improve your net worth over time
as the home gains value (it will eventually, you know). Federal student loans and business
loans, in moderation, can help you boost your lifetime income.
These loans have other things in common: The interest rates are often low and typically
deductible, further reducing the costs of carrying this debt.
Your goal with good debt should be to pay it off, but not until you've tackled your higher‐
Toxic debt should be your priority. Toxic debt comes with high or variable rates and
includes credit card debt, payday loans, title loans and pawnshop loans.
Neutral debt is debt that isn't necessarily toxic but that isn't helping you get ahead either. It
typically includes vehicle loans, fixed‐rate personal or debt consolidation loans, and
retirement plan loans.
Medical debt is a special case. If you've worked out an affordable repayment plan with a
hospital or other provider, you can classify it as neutral debt. If you've signed up for a high‐
interest loan or provider‐supplied credit card to pay it off, it probably belongs under toxic
Private student loans can be tricky to prioritize as well. This debt can help you increase
your income, which can make them seem like good debt, but private loans tend to come
with higher interest rates than federal loans, and the interest rates are variable. In most
cases you'll want to place them at the top of the neutral debt pile or the bottom of the toxic
pile ‐‐ something to be paid off immediately after your nondeductible credit cards, payday
loans and other bad debt.
Prioritize your debts
Now that you've sorted your debts, start with your toxic pile and identify the highest‐
priority debt, which is typically going to be the debt with the highest interest rate.
There are some exceptions. You may want to:
• Target maxed‐out credit cards. If you have a card that's at or near its limit, consider
paying that down first, even if it has a favorable interest rate. Maxing out your cards
can trigger higher rates and torpedo your credit scores. How far you should pay it
down isn't an exact science, but in general you'll want to get your balances below
75% of your limits.
• Pay off a small bill if you need a quick win. If you're really overwhelmed by your
debts, knocking out at least one bill can give you the motivation to keep going.
• Consider accelerating a retirement‐plan loan if your job is at risk. Retirement loans
typically have low, fixed rates, which means they needn't be a priority ‐‐ unless your
job is shaky. Most plans require you to pay back 401k and other retirement plans
quickly after you leave your employer, or the balance you owe becomes a
withdrawal and triggers a fat tax bill.
Remember, you'll pay the minimums on all your other bills so you can throw as much as
possible at your priority debt. Once that debt is paid off, you take the same payment and
apply it to your next‐highest‐priority debt.
Craft your plan
You can use this debt reduction calculator to choose your approach (lowest balance or
highest interest rate) for your toxic debts. It will allow you to try out different scenarios so
you can see how a few more dollars, or a different repayment order, would affect how soon
you'd be of debt.
After your toxic debt is dispatched, you may want to switch to other priorities, such as
building up your emergency fund and saving more for retirement. When those bases are
covered, you can start working on your neutral debt and then your good debt.
Of course, you'll have to find the money to pay down these debts. This might be a good time
to review the information at MSN Money's "Managing your budget" Decision Center.
Before you start throwing any extra money at your bills, try to be realistic about whether
your plan could work.
If your toxic debt totals half or more of your current income, or it would take you more
than five years to pay it off, you might be better off considering other methods, including
credit counseling, debt settlement or bankruptcy.
Implement your plan
If your plan is realistic, put it into place. An online bill payment system can allow you to set
up your payments and quickly transfer extra funds where you want them to go. Remember:
• Don't add to the pile. Stop charging. If you absolutely need to use plastic (for
business travel, for example), use a card that you can pay off in full when the bill
• Find a community for support. Debt repayment takes time, and the support of
others in the same situation can keep you going. Read MP Dunleavey's "The real key
to being debt‐free."
• Review your minimums monthly. Credit card minimums can change if your interest
rate changes. Even if your rate stays the same, your minimum may gradually drop
over time if you don't add to your debt. Consider automatic debits, which allow the
credit card companies to take the correct minimum payment monthly from your
• Don't forget to snowflake. Continue to look for little expenses you can trim, and set
up transfers so the saved money is applied to your debt.
• Calve your way to financial freedom. Apply at least half of any windfall (tax rebate,
refund check, inheritance or bonus) to your highest‐priority debts. These big chunks
can cut the time you stay in debt.
Liz Pulliam Weston is the Web's most-read personal-finance writer. She is the author of
several books, most recently "Your Credit Score: Your Money & What's at Stake." Weston's
award-winning columns appear every Monday and Thursday, exclusively on MSN Money. She
also answers reader questions on the Your Money message board.
Published Sept. 14, 2009