When paying down debt, there are two primary strategies: debt snowball and debt avalanche. They both involve making minimum payments on every debt except for one where you focus paying as much extra principal as possible. Once that debt is paid off, you select another debt to allocate the extra principal payments. The difference between the two strategies is the selection method for which debt to focus on.
The snowball/avalanche element involves rolling not only the extra principal payment but also the minimum payment from the first debt into the next one. For example, you may be tackling your first balance by paying $300 extra on top of a $100 minimum payment. Once that balance is wiped out, you would now pay $400 of additional principal on the next balance. If that balance has a $250 minimum payment, you would then pay $650 of additional principal on the next balance.
Your total monthly debt payment stays the same each month. As you can see, the amount allocated to extra principal increases at each phase, allowing you to pay each subsequent debt at a faster rate. You can build the snowball or avalanche even faster and accelerate debt payoff by increasing the total monthly debt payment along with way, presumably as earnings increase.
The debt snowball method involves paying off debts from smallest balance to largest balance regardless of interest rate.
This method places emphasis on psychological benefits. The debt snowball allows you to reach the payoff milestones the fastest. These mental wins help you build momentum and stay motivated to stick with the strategy. This method is also strongly advocated by Dave Ramsey because he believes that paying down debt is about behavior modification and the smaller goals and quick wins make it easier.
The debt avalanche method involves paying off debts from highest interest rate to lowest interest rate regardless of balance.
This method places emphasis on monetary benefits. By targeting the higher interest rates first, you end up saving time and money. You pay less in interest each month as well as over the whole time period, which in turn allows you to pay off the debt a little faster.
Debt Snowball vs Debt Avalanche: Which is Better?
First, let me ask you this. Which is better: having two debts or three debts?
If you answered two debts emphatically, then you should probably employ the debt snowball strategy. When you break it down, that’s the overriding principle of this strategy. Four debts is better than five. Three is better than four. How can we get there fastest?
If you answered, “Well, it depends,” then you should probably utilize the debt avalanche strategy.
Depending on your personality, one method may be better suited for you personally than the other. But from a strictly financial perspective, this is a no-brainer to me . The debt avalanche is based on logic while the debt snowball is based on emotion. Emotional decisions and optimal financial decisions typically do not go hand-in-hand. If you treat your personal finances like a business, then the debt avalanche strategy should look like the superior option.
But how much better is the avalanche strategy?
Let’s look at a quick example. Imagine we have these two debts:
The debt snowball method dictates paying down the 5k balance first while the debt avalanche dictates paying down the 10k first because its interest rate is higher.
And now we’ll look at two payoff scenarios. One where we can afford paying $400 total per month (extra $100 in principal at outset) to pay the balances down and the other where we can afford $700 total (extra $400 in principal at outset).
When you do the math using this nifty debt payoff calculator, the avalanche method comes out a little ahead. In both scenarios, we would pay the debt off one month earlier at a lower total cost. It’s not a significant difference, but armed with this information, why would you not choose the quicker and less costly option?
Is it worth paying about $300 extra for the privilege of paying Debt A first? To me, definitely not. Depending on whether the total monthly payment is $400 or $700, that’s a 13% or 20% interest savings, respectively.
All Interest Rates Are Not Created Equal.
Remember all you’ve read or heard about the magic of compound interest? Well, with debt that magic is working against you. Not only do you need to look at the nominal interest rate, but also be aware of the type of interest rate. You could be paying simple interest or compound interest. With simple interest, you only pay interest on the principal. With compound interest, you also pay interest on the interest. It’s very plain to see that compound interest costs more.
Student loan interest is typically compound interest that compounds daily. This is the worst for you and explains why lenders love it when you defer payments. Interest still accrues during that time and then you’ll have to pay interest on that interest!
When deciding between two or more similar interest rates in the debt avalanche strategy, it’s much better to knock out one paying compound interest first. This will again save you time and money.
Mathematically, there is really only one poor choice – not paying more than the minimum payments. This ensures you pay the maximum amount of interest with the longest repayment period. In our example above, paying only the minimum payments would result in both debts being paid off in November 2022 at a total interest cost of $3,440.28. That’s a much longer repayment period and much more interest paid than any of the debt snowball or debt avalanche methods.
The debt snowball strategy is significantly better than not making extra principal payments. The debt avalanche strategy is even better.