Two Methods To Effectively Clear Your Debts
What are the differences between Snowball Method and Avalanche Method?
By the end of 2016, 1.25 million (36%) of Cambodian households had some sort of debts or liabilities, according to the 2016 Cambodia Socio-Economic Survey, produced by the National Institute of Statistics (NIS).
The household debt is defined as the amount of money that all adults in the household owe financial institutions. It includes consumer debt and mortgage loans.
This means that by a certain age, Cambodians will find themselves knees deep in debt, be it from their mortgage loan, car loan or their personal loans. There are numerous articles that covers the danger of debts, but what what most articles lack is a proper method to get rid of these debts.
Should you clear the smallest debt or the biggest one? In what order should you be clearing your debts? Most of us are faced with the same situation at the end of every month, but not all of us will bother to find out.
There is basically two schools of thoughts, the debt-snowball method and debt-avalanche method. Each with their Pros and Cons.
Debt Snowball Method
The idea of settling your debt is often based on a simple concept. Visualise and apply the Snowball Method towards clearing your debt – a snowball often starts off as a small sphere, but as it starts making its way down from a hilltop, more snow slabs on as it gains momentum which then creates a giant snowball.
Applying the “Debt Snowball” Method
- Start by listing out the liabilities you are obliged to pay off. Your list should be in incremental amounts from the smallest figure first. Disregard interest rates which may be incurred. Mortgage loan should be left out of this list.
• $10 Telephone Bills (minimum payment $5)
• $200 Credit Card Bills (minimum payment $50)
• $300 Student Loans (minimum payment $100)
• $400 Car Loans (minimum payment $150)
- The second step – with the portion of your salary you have parked away to pay off your liabilities, aim to pay the minimum sums required for all, and with the amount of money you have left, channel it to the smallest liability to be paid off – in the above example, this would be the Telephone bill.
- With the Telephone bill paid off, you are now freed from this one bill, and you can then channel the money to the next smallest liability you have to clear off in the next month. The idea is to eradicate the least complicated debts, which gives you the room to breathe and ease out your list. With this method, you get to see your cash flow slowly gain traction and in time to come, all debts will be cleared.
The “Debt Snowball” Method definitely has its positive and negative sides.
• Your mind comes into play, as seeing the result of eliminating debts off a physical list brings you great satisfaction and a sense of achievement.
• With every elimination, you make your life easier and less stressful.
• Interest rates may swallow you up, depending on how quickly you can settle your debts.
• You also need to have a strong conviction that you will not falter in your repayments – thus rendering this method pointless.
Debt Avalanche Method
Larger than a snowball, an avalanche is a huge mass of snow, ice and rocks rapidly falling off a mountainside. You can imagine the effects this has towards clearing your debts!
Applying the “Debt Avalanche” Method
- List all your liabilities according to the interest rates applicable – starring from the highest to the lowest. Disregard the principle amount owing.
- With this in mind, channel as much money as you can to the liability with the highest interest rate incurred. After this is paid off, you can then move on to the next highest and so forth. You will continue with this until all is paid off.
Positive and Negative of the Debt Avalanche Method
• With this method, you get to reduce the liabilities with the highest interest rates which translates to the best financial logic to be applied.
• This method may be quite daunting as it can be a long-drawn process before seeing your mountain of debts reduced. You will require strong
commitment and discipline to see through this method in order to gain maximum results.