If you have a debt problem, you may have considered other options such as bankruptcy, debt settlement, or credit counseling. However, if you are current with your payments and can make minimum payments, your best alternative is to pay off debt on your own, as the alternatives are expensive and can damage your credit for up to 10 years. In this article we will explain the different payment strategies for getting out of debt on your own and the pros and cons of the different techniques.
If you’ve decided to pay off debt on your own but are confused about the various strategies to best make payments, you’re not alone–there are many competing strategies claiming to be the best. To keep this simple, we will review three popular strategies for making your monthly payments. All three hold the total monthly payment amount constant but allocate this payment differently between the accounts. We will compare these to making minimum payments which isn’t a very good strategy, but we will include it as a point of comparison.
- Constant Payments on each account: with this technique, the borrower pays the a constant amount on each account each month until the debt is paid off. This is the simplest mechanism to execute, but doesn’t allocate debt to the highest interest debts.
- “Snowball”: with this technique, the user holds the Monthly Commitment constant, makes minimum payments on all accounts but the lowest-balance account and allocates as much as possible to this lowest-balance account until it is paid off. After that account is paid off, the borrower shifts focus to the next lowest-balance account and continues to apply as much as possible to this account.
- “Debt stacking”: this is the most efficient technique and is the one advocated by DebtGoal.com, as it can result in savings on interest costs of nearly 10% relative to the other techniques. With this approach you hold your Monthly Commitment constant, but make minimum payments on all accounts but the highest-interest account (your Target account) which receives all excess payments to pay it off as quickly as possible. After this Target account is paid off, you shift your focus to the next-highest interest account, making it your Target, and apply as much as possible to this account while paying only minimums on all others.
To make this simple, let’s assume that you only have two credit cards: one with $4,500 at 15% with a current minimum payment of $180 and a second account with a balance of $6,700 at 18% with a current minimum payment of $268. Let’s also make the big assumption that there are no new charges on the card.
Minimum Payments
As mentioned, this is not a good debt reduction strategy, but it’s a useful point of comparison. With these two cards, you will start with a combined minimum payments of $448 in the first month. However, since each payment reduces principal, your payment in the second month will be less than the first. And since you will pay off some principal in the second month, your month 3 payment is still lower. Although your payments start at $448 in the first month, in month 12 the total payment has decreased to $338. resulting in $110 less being paid toward principal in this month than if payments were held constant. You get the picture…your payments keep declining and although this may sound good, it will take you a long time to pay off your debt: about 11 years, during which you will pay $5,704 in interest. Grade F.
Constant Payments
With constant payments, you simply hold the payment on each account constant over time, even though your minimum payments decrease. This has the advantage of not reducing your payments over time and therefore paying an increasing amount of principal off each month, getting you out of debt quickly. It’s also easy to execute, since you just hold your payment constant on each account. But you could do better by taking the difference between the constant payment and your new, lower minimum payment on your lower-interest card and applying it to your highest-interest card. If you hold your payments constant at the amount of the initial minimum payment, this approach will pay off your debt in 32 months, during which you will pay $2,900 in interest. This is a savings of $2,840 compared to paying only minimum payments, but not top of the class. Grade B+.
Snowball
Thanks to Dave Ramsey, the Snowball approach may be the best known of the three approaches. Under this scenario, total payment amount is held constant over time (here at the sum of the initial minimum payments) but reallocate the amounts freed up by the declining minimum payments to the lowest-balance debt. This can be seen in the payment graph where payments toward the lowest-balance account increase over time. This has the advantage of being the quickest mechanism to paying off an account and giving you a motivational boost, but does not guarantee that this money is being applied to debt efficiently. In this case, it allocates more to the lower-interest debt. Holding your total payment constant at the combined initial minimum payment of $448 pays off debt in 32 months with $2,943 in interest. This option may make you feel good for paying off your first account and you’ll save $2,800 compared to only making minimum payments. Grade: B.
Debt Stacking
This is the most efficient approach of the three. Like the others, we hold the monthly amount constant at $448, but allocate the money freed up by lower payments on the 15% card to the higher-interest card, which we call your Target account. Because it is the most efficient payment strategy it pays off debt earlier, in 31 months with only $2,660 in interest–a savings of 11% compared to the snowball technique. This option is the most efficient and saves nearly $3,100 relative to making minimum payments. Grade: A.
Summary
All of the payment techniques that hold your monthly payment amount constant are dramatically better than just making minimum payments. The most important conclusion is that just by holding your payments constant at the current level of minimum payments you can pay off your credit card debt in just under 3 years without expensive Debt Management or Debt Settlement services that will negatively impact your credit score long after your debt is gone. In short, just by making constant payments you can get out of debt on your own very quickly.
The only disadvantage to any of these techniques is that you will have to maintain a monthly payment schedule. For many people, this can be a daunting task. It is for these people that we have developed DebtGoal.com, an online application to help users create and track against a Debt Stacking plan.
The Impact of Constant Payments with More Accounts
We walked through this example with a fairly simple scenario. With more accounts and different types of debt, the power (and savings) of technique grows. If we add a $320K mortgage at 6.5% to the mix and again hold the payment constant at the minimum amounts over time, the savings become truly impressive. Debt Stacking will save you $119K in interest and get you out of debt nearly 8 years earlier. All without spending more on your debt than you do today.
Additional Resources:
The power of compounding interest
The cost of making minimum credit card payments
Debt settlement
Create Your Debt Paydown Plan
DebtGoal debt reduction plan worksheet
Scott Crawford is CEO of DebtGoal.com, a do-it-yourself system for getting out of debt and lowering your interest costs. DebtGoal.com incorporates all of the techniques discussed in this post and can help users understand and get visibility to and manage their debt finances.
