What is a loan? A loan is an agreement between you and your lender where you get money now, but you have to pay it back later at a certain interest rate. There are two parts to a loan: the first part is the principal, which is the total amount that you owe. If you get a $100 loan, the principal is $100. The second part is the interest, which is the rate at which you will be paying the loan back per year. For example, if your interest rate is 4%, you will be paying back $4 on that $100 loan for the first year. If the next year your same loan is at $50, you will be paying back $2 for that year. I like to think of the interest rate as the rent on that loan that you had to pay annually. A third part of a loan is also the origination fees. Sometimes when you get a loan, you are charged money when the loan officer writes you a loan. Consider that charge to be an expense that you will not get back and not as part of the money that you get from the loan.

If you have just graduated college, or even if you graduated college a while back, and still have a large student loan, along with any other loans, you need to start right away with them paying. There are two agreed-upon methods to approach these loans. I'll explain the pros of each.

The first one is called the avalanche method. With this method, you pay your loans with the highest interest rates first. The advantage of this method is less interest payment over time and you finish paying it off faster. If you’re successful, you will end up with more money in your pocket. The second method for paying a loan is the snowball method, popularized by Dave Ramsey. This method has the advantage of giving more satisfaction, being easier to implement, and maintaining a lower loan-to-value ratio. Keep in mind that for both strategies, you have to be paying the minimums so that you are not charged penalties. It’s also important to make your loan payment on time because if you don’t, then your credit score will go down, and it will be harder to secure a loan in the future. Getting rid of debt is not the only of helping your finances Click Here to learn more ways.

Avalanche Method

The first pro of using the avalanche method is that you are paying less interest over time. Here's some quick math for it. By prioritizing the highest interest rates first, you’re also prioritizing the fastest growing loans. That said, you still have to be making the minimum payments on the other loans.

The second bonus of using the avalanche method is that you will in fact pay off all of your loans faster. This occurs because the amount that you pay monthly toward all your loans is more effective when paying off the highest interest rate fastest. Remember if you pay a 10% loan instead of a 2% loan, you're saving 8% on the total amount owed.

The biggest reason to use the avalanche method is that you will pay off your loan faster, which leads to you having more money in your pocket. Let's say by using the snowball method, it might take you 48 months to pay off your loan. Using the avalanche method, depending on interest rates, you could be done paying off your loans in 44 months. I'm not using exact numbers here, because it is impossible to calculate your exact situation. But using the same payment amounts for both the avalanche method and the snowball method will always prove the avalanche method to be the faster and cheaper option.

Snowball Method

If you are like most people, you probably will prefer the simpler approach. The snowball method of debt payment is much easier to adopt, because you just focus on your smallest loan and pay it off as fast as possible, while making the minimum payments on your other loans.

The main benefit to this approach is the satisfaction you gain by completely paying off a loan. You get to experience a sense of achievement after paying off each loan. This has been proven to encourage you to keep going forward because you can see the progress you have already made.

In my opinion, one of the biggest advantages of using the snowball method instead of the avalanche method is that it helps you get a better loan-to-income ratio. Your loan-to-income ratio is important when you are seeking approval for a new mortgage or when you consider your total cash flow. The way you calculate your loan-to-income is dividing your total monthly expenses by your total income. If you have a total monthly fixed expense of $1,000 and a total income of $2,000, your loan-to-income ratio would be 50%. Lenders tend to use the loan-to-income ratio of 28–36% to give out loans, with 28% implying you're playing it very safe and 38% meaning your risk is the highest it should be. This is a small tangent, but I believe it is important to understand that the snowball method is definitely better if you are a millennial who does not own a home and is considering buying a home soon, primarily because the snowball method will make you more likely to qualify for a loan.

In conclusion, to choose which approach to use to pay down your debt, first write out all of your loans with their respective interest rates. Then, look at the difference between the highest interest rate and the lowest interest rate, and if they are significantly different, pay off the highest interest rate first. If there's not that much of a difference, then it might be worth doing the snowball method for the sake of your loan-to-income ratio. If you spend a little time planning out the best approach right now, you will end up saving huge amounts of time and money in the future.

Set up a coaching session to ensure you’re on the best track to paying off your loans.

By Caleb Basile, CPA