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Avalanche or Snowball?
A Staggering Amount of Debt
The extent and rate at which we tend to take on debt can be staggering, and it's not really that surprising considering the vast number of sources of debt.
Most people will not have the necessary funds to purchase a home for cash, meaning a mortgage is commonplace.
The cost of four-year public colleges has increased an average of 2.7% over the last decade, making higher education more than 30% more expensive than in 2007. It's no wonder that student loans have reached a record $1.5 Trillion dollars in 2018.
This is such a staggering figure that it is difficult to grasp, so let's look at it another way. If I hold down the "$" key on my keyboard until I have 1.5 trillion "$" shown, it would take me over sixteen hundred years!
Credit card debt, according to CNBC, sits at an all-time high of about $6,375 per person. Considering typical credit card interest rates of 18% - 27%, those numbers are likely to increase year over year.
Paying Down Debt
If you face large amounts of personal debt, it may feel impossible make a dent in the sum. Indeed, depending on the amount and how much you make, you may need to consider debt forgiveness programs or other options.
This article is instead for those who have a manageable level of debt, and are making plans for the best way to pay it down.
Let's keep it simple. There are two methods for attacking debt pay-down - the avalanche method and the snowball method.
The avalanche method, so named because it tackles the entirety of the mountain of debt at once, is focused on paying off the highest interest rate debt first. Mathematically, this is the superior method since it tackles the highest losses first.
If this seems counter intuitive, think of it this way. You are essentially "gaining" the payment multiplied by the interest rate of whichever debt you put it towards. If you have $100 to pay toward debt, would you rather multiply $100 by a larger or smaller percentage?
The clear winner is the larger interest rate. You are plugging the biggest holes in the boat.
Unfortunately there are drawbacks. If the highest interest rate loans are also your largest, it will take quite a long time to pay them off (or even see a measurable difference to the outstanding principle). Other smaller loans that are more manageable will stick around longer.
It may feel that you are paying as much as you can, without making an impact. Psychologically, the avalanche method can be damaging to many people. This is where the second method comes in.
Most loans will have minimum payments you pay each month.
The snowball method is so named because it involves paying all of the minimum required payments, plus throwing extra at the lowest principle loan first. After the debt is removed, that minimum payment can be added to the minimum payment of the next largest loan (plus any extra).
As you pay off debts, the payment to the next one becomes larger and larger, like a snowball.
An additional advantage of this method is it addresses the psychological drawback of the Avalanche method. You see debt "buckets" disappearing quickly, which may provide the motivation to keep going strong.
In order to compare the two method, let's imagine you have the following sources of debt:
This brings the grand total to $205,000 of debt with a monthly minimum expense of $4,085. If you have an additional $500 to apply to these payments each month, which debt should you tackle first?
Option 1: Snowball Method
In this case, you decide to pay off loans in this order: Debt C - Debt B - Debt A - Debt D. You do not pay attention to the interest rate in this scenario, instead focusing on getting debts out of the picture and building the payoff snowball.
With this option, all debts will be paid in 61 months. The grand total you will have paid is $275,137.
Option 2: Avalanche Method
In this case, you target the largest interest rate first, ignoring the principle. You pay off loans in this order: Debt A - Debt D - Debt B - Debt C. You'll quickly notice that this is almost the exact opposite order of the Snowball method. Your focus is to plug the largest holes in the boat first.
With this option, all debts will be paid in 57 months. The grand total you will have paid is $261,305.
Comparison in Methods
When looking at the math, it is easy to see that the Avalanche method is superior to paying off loans in the long term.
But in the short term, you may have a difficult time staying motivated. Of the 57 months you are paying these debts, over half the time is dedicated to paying down Debt A when using the Avalanche method. You will go 32 months without seeing any debt bucket disappear.
With the Snowball method, you'll see your first loan (Debt C) disappear in only 20 months.
Dave Ramsey's Reasonable Advice
Cash Flow Considerations
Another consideration is cash flow. If you pay off debt using the Avalanche method, it takes much longer before debts disappear and you can reclaim that payment to use towards other expenses.
Imagine if you found yourself with a major medical expense. If all of your funds are tied up in minimum payments each month, it may be difficult to handle the additional costs. To remedy this, consider setting up an emergency fund before paying down additional debt. Check out my article on Using Bank Account Bonuses to Jump Start Your Emergency Fund to see how we did it.
The Firefly Way
As I mentioned at the beginning of this post, we paid down over $20,000 in debt in just one year. How did we do it?
It should come as no surprise, given the example above. We did the Avalanche method. Yes, I said the Snowball method is probably the best for the vast majority of people. But we are not average people. We look to be just that much better than average.
We are laser-focused on paying down overall debt in the shortest time, with the lowest cost. For this method, Avalanche will always win. Math is math.
Your mountain of debt can seem insurmountable, but it is possible to overcome. It takes work, sacrifice, and careful planning.
The two methods outlined above, Avalanche and Snowball, provide options for paying off more quickly, or more conveniently.
Ultimately, you will need to decide which one to choose, or if a combination of the two makes sense. To see the comparison with your actual debts, take a look at the calculator over at Magnify Money.
If you are actively paying down loans, which method do you use? What arguments for or against have I missed above? Do you have any debt pay-down victories you'd like to share? Let me know in the comments below!