Posted by Shivali Anand
February 7, 2022 | 4-minute read (662 words)
The costs of running a business go beyond just rent and wages; you will also have to deal with courting clients, securing capital and negotiating with impatient creditors. And as your company expands, it becomes that much more challenging to keep up with rising costs.
The question is, how you will deal with the debt that your company accumulates? The debt avalanche and the debt snowball are two common debt-reduction tactics. While both can be effective, choosing the best one depends on your specific circumstances.
If you're a thrifty entrepreneur who takes pride in preserving every penny, the debt avalanche strategy is likely preferable. But if you’re motivated by a quick win or sense of success, the debt snowball strategy is probably the better fit.
We've distilled the key elements of each technique to help you narrow down which is best for your company.
The debt avalanche method
This strategy, also known as debt stacking, reduces your total interest expense. In the debt avalanche approach, business debts are paid off in a sequence based on the highest interest rate to the lowest interest rate, regardless of balance.
Applying the debt avalanche technique:
1. Create an inventory –
List business debts by interest rate for every loan and credit card. Rank them in order from highest to lowest.
2. Pay the required minimum – Pay the bare minimum on all debts listed except the one with the highest interest rate. You must stay current with all debts to prevent penalties and a hit to your credit score.
3. Pay extra on the debt with the highest interest rate – Pay extra toward the debt with the highest interest rate.
4. Gain momentum – Once you've paid off one debt, check it off the list. Start paying off the next-highest interest rate debt using the money you previously allocated to the first debt.
Advantages of the debt avalanche method:
• Long-term savings by minimizing the amount of interest you pay.
• Debt is paid off more quickly.
Disadvantages of the debt avalanche method:
• It offers no positive reinforcement.
• Discipline and patience are required as results take time.
• Requires a steady stream of discretionary cash.
The debt snowball method
The debt snowball method works like a snowball rolling down a hill. It starts small but gets bigger and bigger as the momentum builds.
In this approach, liabilities are paid off in ascending order of size. Regardless of the interest rate, you start with the smallest balance and work your way up to the bigger ones.
Applying the debt snowball method
1. Get organized
– List your debts, starting with the smallest balance and working your way up to the biggest.
2. Pay the required minimums – Make the basic minimum payment on all of your debts except the smallest. This safeguards your credit score and avoids penalty fees.
3. Pay extra on your smallest balance – Put whatever additional money you have toward the smallest balance every month.
4. Build on your accomplishments – Once you've paid off the smallest debt, check it off your list and move on to the next-smallest one. Pay off the next debt using the money you previously allocated toward the first.
Advantages of the debt snowball method
• It reduces your individual outstanding balances quickly.
• You get a psychological boost after paying each debt off.
• You avoid any fees to debt-consolidation companies.
Disadvantages of the debt snowball method• It requires diligence.
• It can lengthen the payback period as it doesn’t account for interest rates.
• Higher-interest debts necessitate a bigger payment.
• Paying down the smallest balances first incurs more interest on the higher-interest loans, making it more costly.
While the debt snowball and the debt avalanche offer efficient strategies to pay off debt, you’ll need to consider which works better for your circumstances. One way to start is by figuring out how much interest you’d be obligated to pay and how long it would take you to pay off your debts under each of the methods.