Business debt can help you boost your company’s cash flow, purchase new machinery, and invest in opening up new markets. But an excess of debt can be counterproductive. If you borrow more than you can afford, worrying about debt repayments could take up most of your time and energy, and hold you back from streamlining and growing your business operations.
If you feel overwhelmed by business debt and monthly loan installments are too much to handle, it’s time to think about what’s the best way to make your debts more manageable. In this article, we’ll explore two different approaches to paying off business debt: the “snowball” and “avalanche” methods.
What is the debt snowball method?
The debt snowball method is a popular technique to help you pay off your business debt. Its name originates from how a snowball gets bigger and bigger as it rolls down a snow-covered hill.
Here’s how the snowball debt repayment method works: First, identify your smallest loan and pay it off as soon as possible with your excess cash. Remember that you’ll be making at least the minimum payments on all your other loans throughout this process. After you’ve paid off your smallest loan in its entirety, set your sights on your next smallest loan and work toward repaying it. If you follow this process, you can gradually pay off all your loans, starting with the smallest and working up to the largest.
While the debt snowball method is based on the dollar amounts of your loans, the debt avalanche method focuses on each loan’s interest rate (more on this below).
Pros and cons of the debt snowball method
As with most other things, the debt snowball method has advantages and disadvantages. Here’s a quick summary:
- Morale booster: Say you’re carrying three loans—one of $10,000, another of $30,000, and a third of $60,000. Using the debt snowball method, you would first pay off the $10,000 loan completely. Although that means repaying only 10% of your total loan amount ($10,000 + $30,000 + $60,000 = $100,000), you would have paid off one-third of your lenders. This could be a great source of motivation and momentum to continue paying off your business debt.
- Easy to understand: The approach is very simple. Just identify your smallest loan, and work on repaying it as soon as possible. Then repeat the process for the following loan.
- Low initial impact: Starting with your smallest loan may not do much for reducing the total sum you’ve borrowed. Since this method relies heavily on creating momentum, it’s easy to get discouraged in the early stages.
- Doesn’t consider interest: Unfortunately, while this method is simple, the debt snowball doesn’t take into account the amount of interest you might be responsible for. So, if your $10,000 loan has an interest rate of 7% but your $60,000 loan has a rate of 12%, you’ll end up paying a lot more in interest if you wait to pay off the $60,000 loan.
What is the debt avalanche method?
With the debt avalanche method, you repay your loans in order of highest interest rate to lowest. This can be a good strategy if one (or more) of your loans carries an inordinately high interest rate, like credit card debt.
Here’s how it works: Like the snowball method, you make the minimum payments on all your debts throughout the process. Meanwhile, you put any extra cash toward the debt with the highest interest rate until it’s fully paid off. Then you do the same for the debt with the next-highest interest rate.
Pros and cons of the debt avalanche method
- Savings on interest payments: Since you’re repaying your high-interest debts first, you reduce your total interest payout.
- Logical approach: If you think about it, paying off your highest-cost loan first is the most sensible thing to do because it should save you the most money in the long run.
- Easy to get discouraged: Sometimes, your highest-cost loan is also your biggest. Repayment could take a long time, and it could be disheartening to keep making repayments toward one loan while all your other loans remain at the same level.
- Difficult to get started: Finding the excess cash to repay your high-cost loan (if it is for a significant amount) may take a lot of work. The avalanche method isn’t as easy to stick with as the snowball method.
When the snowball method makes sense for your business debt
If your business has multiple debts with identical or near-identical interest rates, the debt snowball method probably makes the most sense. The snowball method is straightforward and suited well for businesses with low-interest loans or low-value debts. On top of that, you can easily build momentum using the debt snowball method, knocking out smaller debts first for quick wins. This serves massive psychological value by building momentum and confidence toward repaying the rest of your business debts.
When the avalanche method makes sense for your business debt
The avalanche method works best when your business has multiple high-value or high-interest debts. For example, you might use the debt avalanche to pay off a business credit card with a large unpaid balance and several high-priced business loans. Of course, you need to have a great deal of patience and a steely resolve to tackle your largest debts first. But if you can manage it, you can significantly cut down the amount of total interest you’ll pay when it’s all said and done.
5 tips for paying off business debt
Keep the following points in mind when paying down your business debt:
1. Set up an emergency fund
Don’t lose sight of the big picture in your enthusiasm to get out of debt. Remember that you need to maintain a cash cushion to meet unexpected expenses. So, set up an emergency fund before paying off your debts. Using a sub-account within your main checking account to do this is an excellent idea.
2. Stay up-to-date with your regular payments
Paying your vendors on time is usually more important than paying off your debt. If you delay paying your bills, you could damage the reputation you’ve built for yourself. Also, vendors may hold back raw material supplies or change their current credit terms if you start missing payments.
3. Ask vendors for better terms
Sometimes, it’s just a question of asking for a longer credit period or a bigger discount. Negotiating with suppliers could generate some extra cash to pay off your debts using the snowball or avalanche methods.
4. Reduce your costs
For these debt payoff strategies to work, the extra cash is going to need to come from somewhere every month. Look to implement a cost-reduction program within your company. When you analyze your expenses carefully, you could realize that there’s a lot of unnecessary expenditure you can eliminate—and put that money toward eliminating those debts.
5. Stay the course
Once you decide to adopt a payoff strategy for your business debts, keep at it until you meet your target. If the debt avalanche makes sense for your business and you want to save money in the long run, be sure to stay committed. If you want to see some early progress and aren’t dealing with high-interest debt, then see if you can build momentum using the debt snowball strategy.