By Matthew San Giuliano on The Capital
Good or bad, debt can be overwhelming. Especially when you have multiple lines of it. At times it makes you feel like you’re on a merry go round; making payment after payment without feeling like your total debt has moved. It shouldn’t be that way though. You should feel control over your debt and results from the payments you make on it. For some people, that means a mindset change and for others, it needs to be a more efficient plan. Fortunately, there is an avenue for both.
What are the two paths to paying off debt?
First popularized by Dave Ramsey, the snowball method suggests organizing your debt in order from smallest to largest by sum. You then make the minimum payment on all expenses and put any additional payments towards the smallest sum — working to pay off the smallest sum in its entirety first. For example, if you have three lines of debt you organize them as follows:
Now, say you have $500 a month budgeted towards paying down these debts. After making the minimum monthly payment on all lines of debt you have an additional $125 leftover. The snowball method suggests you should put that $125 every month towards the medical expense every month until it is fully paid off. Then move onto the credit card debt and so on. Making all payments past the minimums on the smallest available balance until you are debt-free.
The benefit of this is not mathematical but rather psychological. In many cases where people stop paying down debt, it’s because they get discouraged from trying to pay off a large piece of debt and not feeling the progress that they stop making any payments past the minimum. They haven’t experienced any real wins because all the small debt is still hanging around and the large debt feels like it hasn’t moved at all.
By instead using the snowball method and paying off the smallest debt first there are instant results. You start to see debt lines disappear and it motivates you to pay off more. It changes the way you think about debt — increasing your motivation to pay it down.
On the other hand, there is the avalanche method. This is where you organize debt by interest rate and pay the debt with the highest interest rate off first. Again while also making the minimum payments on all other outstanding debt. If we revisit the same lines of debt from earlier, by following the avalanche method they are organized as follows:
With that same $500, you still make all the minimum payments, but instead, put the leftover $125 every month towards paying down the credit card debt in its entirety. Once the credit card debt is entirely paid off you move on to paying off the student loan and so on.
Contrary to the snowball method, the benefit to the avalanche method is purely mathematical. By paying off the debt with the highest interest rate first you end up paying less in interest over time thus saving money. By paying less in interest you also cut down the total time it would take to pay off debt. Making this the most efficient route to paying off your debt.
Which approach is better?
Now, most people are thinking why would I ever use the snowball method? I want to pay less and be paying for less time the avalanche method makes the most sense. However, that’s not at all true. The best method to use depends on the type of person you are, how much debt you have, and how much you spend a month paying off debt. You have to be honest with yourself. How accountable are you going to hold yourself and how fast will you get discouraged? While many people believe they can stay committed to paying down debt the truth is they can’t. Other unexpected expenses arise that take precedent and slowly they fall back into only making the minimum payment.
It’s hard to stay dedicated to paying off debt — as reflected by the whopping $14.3 trillion in debts Americans currently face. While there is no one better path here are my suggestions on when to use each path.
When to use the Snowball Method: If you are the type of person who gets discouraged from making payments or frequently has unexpected expenses arise deterring you from paying down debt the snowball method makes more sense. Instead of getting discouraged by trying to pay off massive sums of debt and paying less and less each month, you can focus on the short term wins of paying off small sums and become motivated to pay more and more each month. The behavioral modification would make this a more effective route.
When to use the Avalanche Method: If you are the type of person who is extremely financially disciplined, holds a tight budget, and is not easily discouraged then the avalanche method is a better option. It will save you money in the long run — IF you stick to making the monthly additional payments. While it may not be as gratifying behaviorally it will be financially. It’s mathematically more efficient for the extremely financially disciplined.
Alternative Option: There is no reason you can’t use a hybrid of both methods. For example, you can work towards greater financial discipline by starting with the snowball method. Then transition to the avalanche method once you’ve gotten into a rhythm of making payments. That way you still get the financial benefits of the avalanche method but also reap the behavior modification benefit of the snowball method.
Clearly, each path has its own distinct benefits and there is no right or wrong answer on which method is better. It comes down to you looking in the mirror being honest with yourself and using the method that works that best for you — based on your own personal circumstances. Regardless of the path, you choose debt repayment will require a high level of commitment and determination. But it can and should be tailored to reduce the stress it afflicts on you.