Payoff Debt
Creating a plan of action for paying down debt can be an overwhelming task, especially if your loans are coming from a variety of places with different interest rates (student loans, car loans, credit cards, etc.). And because no one’s debt situation is exactly alike, it’s hard to find clear-cut answers out there on how to achieve financial freedom.
That’s why we at BrainyMoney are highlighting two popular methods for paying off debt: debt snowball vs. debt avalanche. No, these aren’t the only two options out there for getting out of the red, but they’re a great starting point for anyone who doesn’t have a clue where to begin when it comes to controlling their finances.
Take a look below for a full breakdown of each method, as well as the pros and cons that come along with them. Whichever you end up choosing, take pride in the fact that you’ll be setting yourself apart from the 59% of American who don’t even have a budget.
Debt Snowball
The debt snowball approach works by tackling your various debts from lowest to highest amounts. Let’s use a fictional scenario to see how this plays out…
Assume your debt is broken down into four categories: credit card #1 ($2,500 at 17.5%); credit card #2 ($6,000 at 19% interest rate); car loan ($8,000 at 8% interest rate); and student loan ($4,000 at 5%). Using the debt snowball approach, you would pay off your debt in the following order:
1st – Credit Card #1 ($2,500; 17.5%; min payment $55)
2nd – Student Loan ($4,000; 6%; min payment $40)
3rd – Credit Card #2 ($6,000 at 19%; min payment $100)
4th – Car Loan ($8,000 at 8%; min payment 150)
With the snowball approach you pay the minimum amount on every loan before throwing every single extra dollar you have at your smallest loan. Once the smallest loan paid off, you use the money you would’ve have spent toward paying off the next smallest loan, which then creates a snowball effect.
Pros
The debt snowball approach is popular among people who need quick victories to keep themselves motivated. You’ll likely pay off your first debt faster using this method, which will give you the morale boost you need to stay the course. If you’re one of those people who expect to get a 6-pack after one day in the gym, debt snowball may just be for you.
Cons
The debt snowball approach may cost you more money in the end due to interest rates. Take the above scenario for example, where our hypothetical person placed their loan with the highest interest rate (19%) in the third slot. Waiting too long to pay off this loan could result in shockingly high interest fees later on.
Debt Avalanche
The debt avalanche method works just like debt snowball, except instead of paying loans from the lowest to highest amount you’ll be by paying from highest to lowest interest rate. Depending on what your debt looks like, your strategy for paying it off could look completely different than it would using the debt snowball approach.
Using our same scenario from above, the debt avalanche method would look like this:
1st – Credit Card #2 ($6,000; 19%; min payment $100)
2nd – Credit Card #1 ($2,500; 17.5%; min payment $40)
3rd – Car Loan ($8,000; 8%; min payment 150)
4th – Student Loan ($4,000; 6%; min payment $40)
This is called the debt avalanche because it frees up what can potentially be your biggest debt, allowing for an avalanche-type effect where more cash can flow down to your other payments. Proponents of this method argue that a loan with the highest interest rate is also the most toxic.
Pros
Going after the highest interest rate can reduce your interest payments in the long run, and ultimately save you more money than you would with debt snowball. In terms of objective math, this simply makes the most sense. It’s also a great method for people who are able to start a budget and stick with it long term.
Cons
Those who like to see results quickly may want to opt for debt snowball instead, as debt avalanche takes more patience and determination. Your overall mood and temperament while budgeting is an especially important factor according to Dave Ramsey, who’s famous for saying that personal finance is 80% behavior and 20% head knowledge.
Which strategy is the best?
A lot of personal finance blogs out there will tell you there’s no right choice, and we at BrainyMoney agree…kind of.
Because everyone’s debt is different, we can’t tell you to go one way or the other 100%. But just for the heck of it, let’s see how these both of these methods shake out with the help of a debt calculator (courtesy of doughroller.net).
Let’s use the same hypothetical from above with the assumption that $400 can be spent toward paying debt every month. This is how debt and avalanche compare according to the Dough Roller calculator.
The debt avalanche method is clearly the winner in this particular scenario, saving our hypothetical person over $1,300 in interest rate fees. It’s also the faster method – three months, to be exact.
But like we said, your debt payoff strategy is going to vary depending on your situation. We encourage you to play around with this calculator and others around the internet to see what works best for you!
To learn more about the difference between the Avalanche and Snowball method, watch our most popular course, The Core of Personal Finance.
