Just about everyone has to deal with debt in one form or another. Whether it be student loans, credit cards, auto loans or mortgages. In the journey to financial independence debt is a hurdle that usually needs to be overcome before committing to early retirement. The debt snowball and the debt avalanche are two popular methods to tackle debt.
What is The Debt Snowball?
The debt snowball is a debt reduction strategy that begins by paying the account with the smallest balance first while making the minimum payment on larger balances. To do this, list all of your debts including balance owed and the minimum payments. Find your lowest balance debt and start putting any extra money towards that debt. When you knock off your first, smallest balance you then start paying off the next highest debt. You start to gain momentum as your smaller debts get paid off and those minimum payments are applied to your larger balances.
Let’s consider a scenario where one has student loans, credit card debt and an auto loan.
Student loans: $8,000 balance, $50 minimum payment. (6% interest)
Credit card debt: $10,000 balance, $75 minimum payment. (24% interest)
Auto loan: $15,000 balance, $250 minimum payment. (3% interest)
Let’s also assume that this person has an extra $300 per month allocated to pay down their debt. According to the debt snowball method, this person will pay $350 per month on their students loans because this is the lowest account balance. They will also pay the $75 and $250 minimum payments for their credit card and auto loan, respectively.
When their student loans are paid off, they will take the $350 that they were paying towards them and pay that towards their next highest balance, their credit card. They will now be paying $425 per month towards their credit card and the minimum payment of $250 for their auto loan.
When their credit card is paid off, they will take the $425 that they were paying towards it and pay that towards their next highest balance, their auto loan. They will now be paying $675 per month towards their auto loan.
As more loans are paid off, more momentum is gained reducing the time it will take to pay off the next loan.
What is The Debt Avalanche?
The debt avalanche is a debt reduction strategy that begins by paying your highest interest rate debt first, while making minimum payments on your other debts. To do this, list all of your debts including minimum payments and interest rate. Find your debt with the highest interest rate and start putting any extra money towards that debt. When you knock off your first, highest interest rate debt you then start paying off the next highest interest rate debt. Like with the Snowball method you start to gain momentum as your debts are paid off.
Let’s consider the same scenario as the snowball method with the student loans, credit card debt and auto loans.
Student loans: $50 minimum payment, 6% interest. ($8,000 balance)
Credit card debt: $75 minimum payment, 24% interest. ($10,000 balance)
Auto loan: $250 minimum payment, 3% interest. ($15,000 balance)
This person also has the same $300 per month extra to pay down debt. According to the debt avalanche method, this person will pay $375 per month towards their credit card because this is the account with the highest interest rate. They will also pay the $50 and $250 minimum payments toward their student loans and auto loan, respectively.
When their credit card is paid off, they will take the $375 that they were paying towards it and pay their next highest interest rate debt, their student loans. They will now be paying $425 per month towards their student loans and the minimum payment of $250 for their auto loan.
When their students loans are paid off, they will take the $425 that they were paying towards them and pay their next highest interest rate debt, their auto loan. They will now be paying $675 per month towards their auto loan.
What’s the difference?
While these two debt reduction methods are similar in concept they can vary greatly in results. You’ll notice that the debt snowball method focuses on balance remaining and minimum payments while the debt avalanche method focuses on minimum payments and interest rates. The minimum payment figure is less important than the total balance and interest figures, since these figures are what dictate which order debt will be paid.
For efficiency the debt avalanche wins. If your goal is to pay off your debt as quickly as possible and pay the least amount of interest then the debt avalanche is for you. That’s not to say that the debt snowball is worthless. Paying off debts is empowering and by paying small debts first you may get a morale boost that may have taken longer to achieve with the avalanche method. There is a certain intrinsic value that can be attributed to paying off a debt.
Which method do you prefer to pay off debt?
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