Snowball vs Avalanche; choosing the best way to pay down debt
To download and use a free copy my Snowball vs Avalanche excel calculator used for this article, click here.
Debt
Late last year I wrote a few articles about debt. Since then, I’ve received lots of feedback on how these articles have helped readers better understand debt and, more importantly, re-frame the way they view their different types of debt.
Read Debt = a Useful Tool and Don’t Pay Down Your Mortgage!
In these articles, I talk about how we often view all debt as the same. It’s all bad, right? While there’s some benefit to this way of thinking, the truth is not all types of debt are as evil and nefarious as others. We use debt to purchase homes or fund education while also using it to overspend on things we don’t need. These debts are obviously not the same. There are many ways these types of debt differ; different interest rates, different ways of securing the loan, and most importantly, different returns on what we’re purchasing. These debts are not the same and should not be treated the same.
But sometimes
Treating your debt differently and managing their differences can have many benefits. However, sometimes there are reasons why we should lump all our debts together and make a plan to pay them off as soon as possible. There are a handful of reasons to do this, but here are the most common:
1) Nearing Retirement: If you’re nearing your golden years, eliminating debt payments can have a huge impact on your ability to pull the trigger on retirement. For instance, eliminating a mortgage payment, car payment, and student loan payment can remove thousands of dollars from your expenses, making retiring on a smaller income possible.
2) Spending behavior change: If you’re someone who naturally struggles with spending and debt, treating all debt as a burden might be the best option for you. For someone who overspends, feeling the rush of paying down/off debt can have very positive emotional benefits and inspire thrifty behavior in the future. Also, removing debt payments can allow for aggressive saving in order to avoid falling into the debt trap again.
Meet Jill and John, our not-so-real case study
Jill and John Prosperer are both 50 years old, recent empty nesters, and expect to retire in 15 years at age 65. Recently they have begun wondering if retiring sooner might be possible. However, despite their hopes, they know they will probably have to keep working until 65 based on their debt obligations. They have car loans, credit card debt, a personal loan, and, most critically, 15 years left on their mortgage.
After collecting and reviewing all their debts payments, they reach out to their financial planner to see if anything can be done.
Jill and John’s debts
Jill and John’s planner helps them collate their debts and shows them the itemized list:
Jill's Car: Balance $15,000.00, Payment $664.84, Interest Rate 3.10%
John's Car: Balance $22,000.00, Payment $405.73, Interest Rate 6.70%
Credit Card 1: Balance $4,600.00, Payment $115.00, Interest Rate 14.30%
Credit Card 2: Balance $12,400.00, Payment $250.00, Interest Rate 18.00%
Personal Loan: Balance $37,200.00, Payment $755.64, Interest Rate 10.50%
Mortgage: Balance $270,700.00, Payment $1,837.09, Interest Rate 2.75%
The planner
Jill and John’s planner analyzes their information and confirms their conclusions. Yes, based on the mortgage alone, they have 15 years of debt payments remaining.
However, their planner points out there are ways to attack their debt that might be helpful. She first asks if the Prosperers would be willing to pay extra towards their debts. She explains that, not only will larger payments accelerate their goals, she shows them how a larger payment would amplify the effect of lower costs needed in retirement. With the possibility of an earlier retirement, the Prosperers cautiously agree to an additional $400/month in order to see how it could help.
Their planner then lays out two options for them: the Snowball and Avalanche debt payoff plans.
The Snowball plan
Popularized by Dave Ramsey, the snowball method is a powerful tool used towards debt freedom. With this method, Jill and John would commit to paying the extra $400/month and begin by attacking the loan with the smallest balance first. In their case, the loan with the smallest balance is Credit Card 1.
For Jill and John, they apply the extra $400/month towards Credit Card 1, adding to their $115 payment they are currently paying. The planner shows them how this will eliminate the credit card debt in ten months; four and a half years faster than the smaller payment alone. It will also save them over $1,400 in interest over that time!
The Prosperers are encouraged, so their planner continues. Next, Jill and John will apply the extra $400 towards their new smallest balance, which would be Jill’s car loan. However, not only will they apply the $400 extra per month, but they will add the $115 they were paying for the credit card that is now paid off. This brings their extra payment to $515/month on top of their regular payment of $664.84 towards Jill’s car. This shaves an additional six months off Jill’s car payments schedule and saves approx $70 in interest.
This process continues, the momentum of their snowball growing and rolling faster with each debt they pay off, eventually hammering down their mortgage with an astonishing additional $2,591.21/month. This extra payment would have dramatic consequences, removing 7 years from their mortgage and savings them over $21,000 along the way!
All told, the Prosperers are thrilled to find out that the snowball method would save them over $33,737 in payments and, more importantly, allow them to retire in eight years, over 7 years ahead of schedule! $400 dollars a month for an extra eight years of freedom is certainly a worthwhile investment.
The Avalanche plan
The Prosperers are excited about their plan and are eager to get started. However, before they go, their planner mentions another debt reduction option, the Avalanche method.
As the name implies, the Avalanche method is similar to the Snowball method, but with amplified effects. With this method, the same extra $400 payment is applied towards paying off debt, but the loans are prioritized in a different order.
Instead of attacking the loan with the smallest balance first, the Avalanche method attacks the loan with the highest interest rate first. In the Prosperers’ case, they would begin with Credit Card 2 instead of Credit Card 1, resulting in a savings of over $8,000 and taking nearly six years off the loan.
The accumulation of extra payments continues just as the Snowball method, but instead the Prosperers would attack the next highest interest rate each time a loan is eliminated. Mathematically, this method works faster and more efficiently than the Snowball method, but the difference is typically marginal. This marginal difference depends on the size and interest rates of the loans being eliminated. In the Prosperers’ case, the Avalanche method would only save them an additional $1,672.93 more than the Snowball method. Also, it should be noted that the Avalanche method eliminates the Prosperers’ debt in eight years, same as the Snowball method.
How to decide
If we were all computers, we would always choose the avalanche method. The added savings and possible time acceleration in debt payoff should be a strong enough argument by itself. After all, mathematically it makes the most sense.
However, we aren’t computers. While the Avalanche method technically works the best, for most people the Snowball method makes the most sense conceptually. After all, why put $400 extra towards a larger loan instead of completely eliminating a $250 loan only because of a difference in interest rates? Simply, for those seeking emotional or behavioral wins, the snowball method makes more sense and provides those “payoff wins” sooner. For those more practically, mathematically oriented, they might prefer knowing they are choosing the best statistical choice. For those types, the Avalanche is the best choice.
The Prosperers
For Jill and John, the difference between the Avalanche and Snowball isn’t important. For them, the important thing is that they are on their way to retiring earlier. Regardless of the method they choose, they are accelerating their path to their goals with each extra payment.
If debt is standing in the way of your goals or if overspending is an issue, these methods will help. As always, identify the goal, make a plan, stay flexible, spend less than you make, and pursue your prosperous life.
