Should you use the avalanche or snowball method to pay off your debt? Here’s a primer of both methods to help you choose what strategy works for you.
Got debt? It turns out that a lot of Aussies are also burdened with loans. Moreover, we don’t really wanna talk about it.
One-quarter of Australians ignore their debt because they don’t want to discuss it, which is leading to feelings of anxiety and embarrassment, an ING study found.
A spokesperson for ING, David Breen, said that “the problem with not talking about debt is that options to solve the problem don’t then readily present themselves”.
But now you are ready to take control of your finances. You have decided to start paying off your debt. Great!
However, attaining a debt-free life is easier said than done. You’re not quite sure what method to use to tackle your numerous debts, which can be an overwhelming mix of credit card debt, personal loans, student loans, car loans and payday loans.
These debt avalanche and debt snowball methods are almost exactly alike in that they both ask you to list all your consumer debt and pay the minimum payments on all but one of them. The aim is to first clear the debt that you’re paying higher than the minimum. The methods only diverge over which debt you target first.
Let’s learn about the difference between the two methods to help you decide which one is best for you.
What is the debt avalanche method?
Both methods start out with listing your debts, but differ in what they prioritise.
With the debt avalanche method, also known as debt stacking, you organise your debts by interest rate from highest to lowest, regardless of the balance. It involves making minimum payments on all your outstanding accounts, then using any remaining money to pay off the loan with the highest interest rate.
If the debt with the highest interest rate is paid off, you then apply the same strategy to the one with the second-highest interest rate, until it is all paid off.
The method is called avalanche because it aims to create momentum, similar to an avalanche that starts small and gathers more speed and power as it goes.
Pros and cons of the debt avalanche method
The main advantage of the debt avalanche method is that you can save hundreds of dollars in interest payments with it.
For people with bigger amounts of debt, this method can also significantly lessen the time it takes to pay off the debt by a few months. If you’re able to make substantial payments while still having enough money for your daily living expenses, this can be a good way to help you get out of debt quicker.
Sounds foolproof, right? However, it also has its downsides. It requires strict discipline to put all your extra allocated into paying a particular loan, and not just the minimum payment. Skipping by just a month or two of strategic repayments can derail this strategy and it will not work as effectively.
This approach also assumes that you have a specific and constant amount of discretionary income you can use to pay your debts. This means that an increase in your living expenses (rent, groceries, utilities, etc) or emergencies could throw a wrench into the strategy.
What is the debt snowball method?
With the debt snowball method, the focus is on the amount of your debt and not the interest rate. Simply put, you pay off your debt from smallest balance to largest balance.
Make a list of all the outstanding amounts you owe, in ascending order of amount. The interest rate is not factored in. The idea is to pay off smallest debts first to get them out of the way before moving on to bigger ones – the embodiment of the “tackle the easy tasks first” approach. You can think of it like a snowball rolling down a hill and gathering more speed and size as it goes.
The smallest loan will be your first target, putting as much extra money into each payment at your discretion.
Much like the avalanche method, you will pay just the minimum payment for the other loans. When the first smallest loan is settled, you can move on to the second smallest one for the extra payment treatment. Repeat this process until you plow through all your debt.
Pros and cons of the debt snowball method
The main advantage of the debt snowball is that it helps build motivation.
Paying off what you owe is not an exciting prospect. Especially if you have plenty of little debts to take care of; keeping track of several minimum payments can be overwhelming. And it’s even harder if you don’t seem to be making a dent to your debt. Without a sense of progress, it’s very easy to get demotivated and go off track.
Personal finance author and talk-show host Dave Ramsey, a vocal advocate of the snowball method, points to our need for instant gratification that makes the snowball method so effective.
“The math seems to lean more toward paying the highest-interest debts first,” he said. “But what I have learned is that personal finance is 20 per cent head knowledge and 80 per cent behavior. You need some quick wins in order to stay pumped enough to get out of debt completely.”
When you pay your debts from the smallest to the largest balance, you can begin to be free of those little debts at a fast pace. This gives you a sense of progress, as well as gratification. You are motivated by the improvement in your financial situation.
In the long run, tackling bigger debts such as your car loan or large credit card balances will be easier for you because you have the confidence as well as the extra cash flow to clear all your debt.
Eliminating several outstanding balances in only a few months helps you stick with the plan and makes it seem that the mountain of debt you’re facing can be conquered.
Additionally, it’s easier to implement. You don’t need to compare interest rates and annual percentage rate (APR), you just have to focus on the amount.
The big disadvantage of the debt snowball is that it can be more costly overall. Because you are focusing on balances over the APRs of your loans, you could end up paying more in interest. Compared with the avalanche method, reaching debt-free status could also take a longer period of time, depending on the nature of debts and how frequently the interest rate on the loans compound.
Snowball v avalanche: Which is better?
So, what is the best repayment method?
The snowball and avalanche methods are nearly identical in that you’ll be able to pay off your debt quickly (depending on how much debt you have).
Determining which is the better approach will depend on whether we’re speaking in financial or psychological terms.
If you’re looking to save money, the math shows that debt avalanche is the more effective method. Because you pay debts based on their APRs, you end up paying less interest. This means a less expensive debt payment, given that you follow through with the payment plan.
But humans are often irrational (and sometimes emotional) when it comes to money. For some people, it may be much easier to stay motivated if they clear the smaller debts first, regardless of interest rate.
So, while the snowball method may cost more, it’s psychologically better for them because they are more likely to stick with the strategy. It also prevents them from giving up on the plan or worse, sliding back into debt.
Does the debt snowball/avalanche really work?
In the end, both debt repayment strategies are useful and can help you regain financial freedom. Your financial situation as well as your personal preferences should also be taken into consideration when choosing which strategy is best for you.
Get in touch with us at 08 8211 7180 or info@centramoney.com.au to find out how we can help you reach your financial goals.
Article courtesy of Nestegg.