The Bank of Canada lowered its key interest rate last week, to 2.5 per cent, after a hiatus from rate reductions earlier this year. This means the interest rates on many lending products, tied to the central bank’s new lower rate, are now less. More of the payments you make on products like lines of credit and loans with a variable-rate component now go toward the balance, and less toward interest.
If you want to capitalize on the new lower rate, strengthen your finances and reduce stress, paying off debt is a solid strategy.
There are two winning debt-reduction methods. Choosing the one that’s best for you, and the one you’ll be more effective at executing, has a lot to do with your psychological makeup.
Is the snowball method right for you?
The snowball method, which focuses on motivation, is usually better for people who need frequent psychological wins. This kind of momentum and progress provides the motivation to stick with it and pay off debt, even when the temptations to spend creep up. This method encourages streamlining all aspects of banking; fewer accounts and consolidation of debts.
Snowballers often struggle with impulsive shopping and spending (landing them in debt in the first place). They have a hard time focusing on long-term financial goals and aren’t likely paying attention to their interest charges. It’s common for snowballers to start the snowball process with an overwhelming number of accounts for banking, credit cards and loans, spread out across different financial institutions. Their wallets, glove boxes and purses are full of cards … and a gazillion receipts.
Is this you? Try the snowball method of debt reduction.
How the snowball method works
You’ll pay off your debts starting from the smallest balance to the largest, regardless of the interest rate. The psychological benefit is that you’ll see quick wins early, which builds motivation and momentum.
To set it up, you’ll list your debts from smallest to largest. You’ll continue to make minimum payments on all debts, however you’ll pay a little extra — even $10 or $20 a week — toward the smallest debt until it’s gone. Then you’ll move on to the next smallest debt, rolling over the freed-up payment into it — this is the “snowball” effect. The main drawback is that you could pay more interest over time, since the higher-rate debts may linger longer.
Is the avalanche method right for you?
The avalanche method, which focuses on math and logic, is better for minimizing cost and length of time in debt. This method works best for people who are highly analytical and numbers-driven, and are just plain patient. Small milestones and “quick wins” aren’t key motivators; the greatest possible savings on interest is.
Avalanchers tend to start out with bigger balances and steep interest rates on credit cards, HELOCs, loans or even private loans between friends and family members. They have a good awareness that the magnitude of debt can take years to pay off, and are familiar with interest charges. Many have complex budgets, yet struggle with cash flow management.
Is this you? Try the avalanche method of debt reduction.
How the avalanche method works
The avalanche method saves the most money in interest and gets you out of debt faster, but requires delayed gratification. You pay off debts starting with the highest interest rate first, regardless of balance size.
To set it up, you’ll list debts from highest to lowest interest rate. You’ll carry on making minimum payments on all debts, however you’ll direct all extra money to the highest-interest debt, typically on a weekly basis, until it’s paid off. Even smaller sums help. Once that’s gone, you’ll move on to the next highest-interest debt, and repeat.
Progress can feel slower, since the highest-interest debt might also be a large balance. The motivation is knowing you’ll save the most money on interest as possible.
Both the snowball and avalanche methods can be powerful tools for paying down debt, but neither will stick if spending habits and budgeting issues aren’t addressed. I’ve seen families wipe out $70K only to be buried again within a year because the root cause went untouched. Fix the behaviour — your money psychology — and the method will work. As the debt comes down, and you prove to yourself you can do this, you’ll feel better.
