Those of us who took out student loans for school or weren’t as diligent about our finances in our younger years, may have accumulated some debt. Now that we have started our careers and are trying to follow a budget, one of the things on our to-do-list is paying off debt (or at least making payments towards it). When it comes to paying down debt, there are 2 main ways to do it: the debt snowball and the debt avalanche.
With the debt snowball method, you organize your debt by the amount you owe on each loan and prioritize paying off the loan with the smallest amount first. One you pay off the loan with the smallest amount, you use the money you were putting towards that loan and stack it onto what you were paying on the next highest loan until you pay that one off too. You keep stacking payments and paying off loans until all of your debt is gone.
Example of the Debt Snowball:
Let’s say you owed $5,000 on a credit card, had $20,000 left on your car loan, and $40,000 in school loans. With the debt snowball method, you would prioritize paying off the credit card debt first, then the car loan, then your student loans. Specifically speaking, you would make the minimum amounts on all loans (say $100 each) and any leftover money you have (say $500) would go towards the smallest loan (in this case it would be your $5,000 credit card debt). Once you pay off the credit card debt, you would stack the money that went to that debt onto the next highest loan, which in this example is the $20,000 you still owe on your car. Once you pay off the car loan, you would take the money you were paying on that loan and add it to what you were already paying towards your $40,000 student loans. With the debt snowball, you end up stacking money on each payment as you pay off each debt (like you creating a snowball that stacks ice as it rolls).
Why the Debt Snowball works:
Paying off debt is mental. When you see yourself pay off the small loan, you may be even more encouraged to pay off the larger loans and more likely to eventually eliminate all your debt. The disadvantage of this method is that paying off loans with the smallest amounts first may cost you more money overall (since there may be other loans with higher interest rates). Despite this disadvantage, there are many advocates of the debt snowball method. Supporters of the debt snowball say that most people don’t end up paying off all of their debt because they get discouraged along the way. However, when they see themselves pay off one of their loans, they are more likely to pay off additional loans and eliminate their debt altogether. Thier point? People may pay more money overall with the debt snowball method, but they will eventually get it all paid off.
With the debt avalanche method, you organize your debt by the interest rate on each loan, (not by the amount you owe on each loan). You prioritize paying off the loan with the highest interest rate first (even if you have other loans of smaller amounts).
Example of the Debt Avalanche:
If you had the same loans from the previous example: $5,000 from your credit card with a 15% interest rate, $20,000 from your car loan with an 5% interest rate, and $40,000 in student loans with an 8% interest rate, then you would organize your loans by their interest rates and prioritize paying off the loan with the largest interest rate first. In this case, you would pay off the $5,000 loan, then the $40,000 loan, and end with the $20,000 loan (as if you are an avalanche that starts at the top of mountain and increases in speed as it travels downward).
Why the Debt Avalanche works:
The advantage of this method is that you end up paying less money overall because you get rid of loans with higher interest rates first. The disadvantage of this method is that oftentimes the loans with the highest interest rates are some of our larger loans. Thus, it may take awhile to actually pay the loan off. It may be harder to feel as though you are making progress towards debt repayment since paying off that first loan could take years. Many people may lose their zeal for paying off debt and get tempted to use that money for other things. Nevertheless, many financial advisors still recommend the debt avalanche for people who are dedicated to becoming debt-free, since it saves them hundreds, if not thousands, of dollars in the long-run.
Which method is better?
It depends. There are pros and cons to each method so you should choose the method you think you can stick to the best. If you know you are the type of person who needs to see small victories to stay encouraged along the way to becoming debt-free, then perhaps the debt snowball method is right for you. If you are the type of person who is more diligent about paying off debt, doesn’t rely on small victories, and has fully committed to paying off debt in the shortest amount of time, then perhaps you would do well with the debt avalanche method. I myself, have used each of these methods in the past and they both have worked well. For example, I used the snowball method when paying off my car note and credit card bills. I then used the debt avalanche method when paying my student loans.
Which method do you think would work best for you?