Hey everyone! Daniel here from Next Level Life. Today I realized that I’ve been ignoring another big area of personal finance … debt. I don’t know how I can be a self respecting financial blogger if I don’t at least touch on that subject.
Today I’m going to be talking about debt. More specifically, I’m going to be talking about two very popular ways that people try to pay off their debt. Those are the debt snowball strategy and the debt avalanche strategy.
I’m going to be talking about how both strategies work, as well as the benefits and downsides to each. Then, I’m going to wrap it all up by comparing both in a very similar example to see which works better.
First, I’m going to be talking about the “debt snowball”. How does it work? Well, the debt snowball (as made famous by Dave Ramsey), tells you that you should be paying off the debt with the lowest balance first, regardless of what the interest rates on all your loans are.
You order them from smallest balance to largest balance, then pay them off in that order, making minimum payments on all of them, except the smallest — which you attack with a vengence, throwing everything you’ve got at it, selling so many things the kids think they’re next. You do that until you’ve paid off that smallet debt.
Once you’ve paid off that smallest debt, you take that minimum payment that you were using against the smallest debt, as well as all the other extra money you were throwing at it, and you move it to the new smallest debt. When I get to the example I’ll put some numbers to it so it makes a little more sense, but that’s basically the concept.
The benefits, of course, have been found to be very psychological in nature. Because you’re paying off the smallest balance first, you see progress very quickly (at least in comparison to other debt payment strategies).
As each month goes by and you pay off more and more of your debts, you get less and less bills coming into the household and that motivates you even more to continue paying off debt. The momentum continues to build up until you’re finally debt free.
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That’s the theory anyway, but there has at least been some evidence to back it up. In fact, the Harvard Business Review did a study recently and found that people using the debt snowball did tend to finish paying off their overall debt more often than other people who use other strategies.
That’s not to say there aren’t downsides to using this strategy as well. The main one that people end up throwing at the debt snowball is that it’s not the most mathetmatically efficient way to pay off your debt. That is absolutely true. Probably the most mathematically efficient way to pay off debt is to use the debt avalanche, so let’s get into that.
The “debt avalanche” is, as one of my finance professors back in college would say, “Similar, but different.” The debt avalanche says that, instead of ordering your debts from the smallest balance to the largest balance, you should instead order them from the highest interest rate to the lowest interest rate, and pay them off in that order.
The benefits, of course, is that you do get out of debt faster than compared to the “debt snowball strategy”, because you’re paying the higher interest rate debts off first, which means you’ll end up paying less interest overall in the long run. With more of your money going toward principal, the debts do get paid off faster.
The downside to the debt avalanche, in my opinion, is that it doesn’t really take emotions into account. As I said just a moment ago, studies by the Harvard Business Review have found that the debt snowball does tend to lead people into paying off more of their overall debt in the long run.
So let’s go through a quick example here to show how these two strategies work. Let’s take John and Jane. John is going to use the “debt snowball to pay off his debts. Jane is going to use the debt avalanche. For the sake of simplicity, I’m going to assume that they both make the same amount of income, and they both have the same amount of taxes, the same amount of expenses, and the same amount of debts.
I’m going to have them have a $25k credit card balance, a $20k in student loans, and a $10k car loan. The interest rates for both John and Jane are going to be 15% on the credit card, 4.45% on the student loans, and 4.21% on the car loan. I chose these numbers mainly because they seem to be right around average.
The minimum monthly payments on the three debts will be $750 per month on the credit card, $200 per month on the student loan and $185 on the car loan.
The income for both John and Jane is going to be $59,000. They’re both going to have expenses of $24,000. As for taxes, they’re both going to take the $24,000 standard deduction and pay about $8750 a year to the government. That means that both, after taxes and expenses, are going to start with about $1052 left over at the end of every month after making their minimum payment on their debts.
I did the numbers this way because it leaves the credit card balance as the biggest balance and the highest interest rate. We’re going to see as big of a difference as we can between the debt snowball and the debt avalanche.
We’ll start with John. As I said, John will be using the debt snowball to pay off his debts. Since he’s using the debt snowball, he’s going to start by trying to throw everything he’s got at the car loan, which is $10,000. He’ll make the minimum payments for each, but on top of that, he’s going to take his entire $1052 remaining at the end of the month and put it on the car loan. By doing this, he will have the car loan paid off in full in 9 months.
Now his snowball payment will increase, since he’s no longer having to pay $185 per month toward his car loan. That means his new snowball payment is $1237 per month, now that he’s going to start making student loan payments, since that’s the next lowest balance. For the sake of simplicity we will assume that the balance is still $20,000. Starting at month 10 of his debt payment strategy, he will start knocking out that student loan as fast as he can. Running the numbers, we find that at the end of his 23rd month of his overall debt payment plan, he knocked out the student loans completely. Now, all he has left is that credit card bill.
Again, for the sake of simplicity, we will assume that the debt is still $25,000 without interest. John’s snowball payment again increases, because he’s no longer having to put $200 a month to make the minimum payments on the student loans. That means his snowball payments go from $1237 per month, to $1437 per month. He make the minimum payment on the credit card, and makes all that snowball payment as well, and pays off the credit card, in full, at the end of the 35th month.
In about 3 years, John managed to pay off a $10k car loan, a $20k student loan, and a $25k credit card bill. Now how does that compare to Jane?
Jane is using the debt avalanche. She has the same debt, same income, same expenses. Except, she is paying off the debts in a different way. Using “debt avalanche”, she pays off the the debt with the highest interest rate first, regardless of balance. She’s going to throw everything at the credit card bill right from the start. What we see is Jane takes quite a long time to get that credit card debt repaid, which is understandable as it has a very high interest rate and it was the largest debt to begin with.
But, whereas John managed to pay off his first debt and see some progress at the end of 9 months, Jane doesn’t see any progress until the end of the 16th month. That is almost twice as long as John, but on the bright side, she does have the credit card bill paid off in full. The biggest hurdle for her is done. Her starting payment was $1052 dollars, now it becomes over $1800 because she no longer needs to make the card bill minimum payment.
All of that now goes toward her student loan, which is the next highest interest rate at 4.45%. She will do that starting in month 17 of her debt repayment plan, and she will have it paid off in full by the end of the 26th month. Now, all she has left is the car loan. She can now take the $200 that she no longer needs to pay toward her student loans and now lump it into her avalanche payment, which is now over $2k per month. By the end of the 30th month, she is debt free.
She paid off the same amount of debt as John, but she did it in 30 months, where John took 35 months. The biggest reason for that is the difference in interest payments.
John, using the debt snowball, left his credit card bill until the end. It was the highest balance and the highest interest rate. He accumulated a lot of interest payments. In fact, he paid over $10k in interest over those 35 months. Meanwhile, Jane in her 30 months of debt repayment, only paid around $4700 in interest, because she knocked out that cash loan right away.
Looking at the two and comparing them, there’s not really any question as to which one will get you out of debt faster. Debt avalanche will get you out of debt faster (if you stick to it). The reason the debt snowball is more popular is that it’s very hard to stick to the debt avalanche when you’re not really seeing any tangible progress for so long. Remember, Jane did not have her first debt paid off until 16 months into her debt repayment strategy. That is a long time to not see any progress, even if you know it’s going to a good cause.
So which debt repayment strategy is right for you? It really just comes down to knowing yourself and how you would handle it. Which will motivate you more? Knowing that you’re going to get out of debt faster, even when you’re not seeing any tangible progress right away? Or, seeing the tangible progress, seeing less and less bills coming in the mail every month, even if it means you’re going to pay a little bit more interest in the long run.
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