If you have several debts spanning across many creditors, it can be overwhelming and challenging to know where to start. It might seem that the best place to start is with the most significant debt, as this will often have the most interest, but this isn’t always the case as the consequence of paying off some debts will be higher than others.
Split your debts up.
The first step is to split your debts up into priority debts, non-priority debts, and emergency debts.
Emergency debts are what you need to focus on first, and can include court or bailiff action or a warning that you may be evicted for missing rent or mortgage payments. If you're in this situation, you must speak to a debt advisor who will give you advice and talk to your creditors for you. If there's court action being taken and you're required to speak at a court hearing, then make sure you don't miss your appointment, as this is where you'll be able to give information about your situation, which may lead to a decision that's better for you. With a debt advisor working with you, make paying off or creating arrangements to pay off your emergency debts your number one priority, as if you ignore them, you may have to face significant consequences.
These are the next more important debts you'll have to deal with to the impact you'll face if you don't pay them, and not necessarily the size or interest rate of the debt. Priority debts include fines issued from the court, council tax, gas and electricity bills, and rent or mortgage payments. If you fail to pay these debts, you may face court summons, visits from bailiffs, or losing your house, electricity, or heating. These are all difficult situations to be in, so they must be prioritized, even if you have other debts that have larger monthly payments.
These are other debts such as overdrafts, credit, store card debts, and other private loans you may have. Non-priority loans will result in less severe situations if not paid, but this doesn't mean you can ignore them as they will also often have the highest interest rates. Suppose you have a significant number of priority and non-priority debts, but don't have the income to pay them. In that case, you may seek financial help by combining them into a debt management plan, or individual voluntary arrangement through a company like Jubilee 2000 UK.
Debt avalanche or debt snowball?
When it comes to paying off your debts, you can use two main strategies to maximize your payments and get rid of your loans as quickly and effectively. For both the avalanche method and the snowball method, the first step is to list your debts, and then pay the minimum amount on all of them except one. Note that this assumes that you have no emergency debt, and that most of your debt is from non-priority loans.
Debt avalanche strategy
The debt avalanche method has you making the minimum payments on all your debts, and then targeting your debt with the highest interest rate and paying off as much as possible. The avalanche strategy is the most effective for paying off your loans with the lowest amount paid by the time you're finished.
For example, if you have three loans at the following amounts and interest rates:
Credit card debt of £10,000 at an interest rate of 18.99%
A car loan of £9000 at an interest rate of 3%
Student loan of £15,000 at an interest rate of 4.5%
It may seem like you should target the student loan first, as this is the most considerable overall debt. Still, in reality, the credit card debt will increase faster, and if you don't prioritize it, it will result in a far higher total amount paid if not prioritized. If you have £3000 available to pay off your loans and focus on the credit card loan first, you'll be able to pay off all of these debts in 11 months and have paid £1011.50 in interest. If you focused on the other debts first, you'd pay a total of £1514.97 in interest, which is a significant amount, and if you were paying only £1000 per month, this would take far longer and the amount of interest you pay over the period far higher.
While the avalanche method is 'on paper,' the most effective way to pay off your debts, the snowball method can be useful from a mental perspective. The snowball method has you picking your smallest debts first and paying these off, working your way to the larger debts, giving a sense of accomplishment and progress as you tick off each debt. When paying off loans, and especially big ones, it can feel like you're not making much progress as you slowly pay off an amount over what can be years. By picking small debts first and paying the maximum amount on them, you may find that you have paid them off in just a couple of months, which can offer a significant amount of emotional weight off you and can give extra motivation to pay off the next loan. When it comes to paying off your bigger debts, even though the amount is larger, you don't have the mental baggage of knowing that you still have four or five other debts still with your name on them.
While the debt avalanche method is technically the best, it won't be useful if you lost motivation in a few months and start skipping payments. The snowball method may be more effective because it will keep you on track and making progress, and the decision comes down to your personal preference. Pick the method you know will be most effective for you, or choose one of these techniques and see how it works for you. If you find that your chosen strategy isn't working for you, then move to the other. The important thing is that you're making progress in reducing your loans and getting closer to debt freedom.