Mortgages, cars, appliances, credit cards…debt piles up, and without knowing how to let go of the rope around our neck.
This is happening to more and more people all over the world.
The International Monetary Fund said this month that global private debt rose by 13% of global GDP (gross domestic product, the sum of a country’s goods and services) in 2020, the largest increase in the past two decades.
In some Latin American countries, the majority of the population owes money to financial institutions, such as in Peru, where more than seven in 10 people said they owed in a recent survey by consultancy Datum.
And in the United States, credit card debt reached a record $890 billion this month after growing by $100 billion in one year, according to the Federal Reserve.
When repayment obligations accumulate, many debtors adopt strategies to meet their obligations as intelligently as possible.
Two of the methods most recommended by experts are known as “avalanche” and “snowball.”
Below we explain what it consists of.
If you are a balanced, patient and computer person, your strategy is avalanche.
First, you should make a list of all your debts and rank them in the highest order. Lowest interest rate.
Your goal is to pay the minimum required of all of them.
And for the person with the most interest, set aside all the extra money you can get each month until you pay it off.
For example, if your mortgage is 8%, the TV you bought is 12%, your car is 15%, and your credit card debt is 25%, contribute all of your money. As much as possible to settle the latter, always adhering to the minimum payments of others.
Once you clear your credit card balance, use your extra budget each month to cover car payments, then TV, and finally the mortgage.
The effectiveness of the avalanche lies in the interest rates, which on most loans represent an important part of the monthly payments.
The higher the price, the more money is allocated to cover interest costs and less corresponds to the principal or the value of the product itself.
With this method, you’ll save money by preventing the accounts with the highest interest rates from continuing to add to your debt indefinitely. Math doesn’t lie.
But math isn’t everything.
A debt situation can cause high levels of stress, so psychology is a factor to consider.
Seeing debt build up over time can be discouraging and hinder your efforts to reach your desired zero balance.
Take the above case: you have a mortgage of $100,000 (about R$515,000), you just bought the TV for $1,000 (about R$5,500), and you have $5,000 (about R$5,000) of his car and owe it yours in the amount of US$10,000. on credit cards.
If your number one goal is paying off credit card debt, but your income is limited, it can take years to achieve that, and without strict discipline, you could throw off the towel halfway.
Then you can go for a snowball strategy.
First, list your debts as in the previous case, but order them not by interest rate, but by value.
Sure, make minimum payments for everyone, but set aside all the extra money you can cover the minimum amount until you pay.
In this case, you should do your best to pay for the TV first.
An achievable goal, right?
Upon reaching the first goal, you will soon see the results of your efforts, which should further motivate you to keep paying for your car, credit card, and mortgage in that order.
Although from a purely mathematical point of view, a snowball is less efficient than an avalanche, according to experts it can achieve the same or better results.
There is also the possibility of combining the two methods: first pay the smallest debt, with the first success motive, go to the avalanche strategy to face the rest of your debts.
It is essential to manage your debt well
For Mexican academic and financial expert Norman J. Wolfe, both strategies can hold true as long as there is a steady income.
And if you’ve raised too much, “another reasonable option is to consolidate the debt into one bank,” he says.
In an interview with BBC News Mundo (BBC Spanish Service), Wolff, a professor at the National Autonomous University of Mexico, offered some tips for managing your debt in the smartest way possible.
“The first step is to figure out what we’re hiring when we buy something. It’s essential to look at the consumption schedule, and if you don’t understand, ask a professional for guidance.”
This table shows all the payments that must be made on the loan, such as how much principal and interest must be paid and what debt is due in each period.
“In the long run, what we’re looking for first is the principal payment: the ability to make large payments that pay off the outstanding balance and so the interest goes down,” says Wolf.
The specialist ensures that, in an inflationary moment like the present one, it is better to “give priority to depreciation operations in which more capital is paid out first and interest is left last”, which is the data that must be included in the amortization schedule.
And in case he has to choose between a snowball or an avalanche, he leans more towards the latter.
“You can see what the most aggressive interest rate is, and I would say, pay off the debt at the highest rate first and then pay off the debt at the lowest rate.”
– This text has been posted Originally in https://www.bbc.com/portuguese/internacional-62582972
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