Avalanche vs Snowball – debt repayment methods
A recent Q & A on moneystepper, discussed debt repayment. In this debate, we came across two different debt repayment methods, both of which are supported by finance professionals and advisers: snowball and avalanche. In my opinion, avalanche is a better debt repayment method than snowball. Here is why.
The first theory of debt repayment is “snowball”. The snowball method is a debt reduction strategy, whereby if someone has more than one debt, they pay off the accounts starting with the smallest balance first while paying the minimum on larger debts. Once the smallest debt is paid off, the individual proceeds to the next slightly larger small debt above that, so on and so forth, gradually proceeding to the larger ones later.
This method has gained recent recognition because it is the primary debt-reduction method taught by many financial and wealth experts. The popular financial talk-show host Dave Ramsey is a well-known proponent of the method.
The benefit of snowball is the psychological benefit. Supporters argue that seeing results sooner (ie you can completely pay down one debt and cross it off your list) encourages the continued repayment of debt.
The second theory of debt repayment is “avalanche”. The avalanche method is also a debt reduction strategy, whereby if someone has more than one debt, they pay off the accounts starting with the highest interest balance first while paying the minimum on other lower interest bearing debts.
The adoption of this method can often lead to it taking longer to wipe out the first debt, but will always ultimately lead to a reduction in the interest repaid overall.
Which is better?
In my opinion, as a mathematician, there is only one choice when it comes to debt repayment: avalanche. Our aim when paying off our debt is to reduce our money which we pay in interest, or “trash cash” as I like to call it. If reducing the money we are wasting isn’t incentive enough, I can’t see how the “psychological” advantages of snowball is going to help you.
Let’s explain just how significant the difference can be. unbury.me is a very useful website to show the discrepancy between avalanche and snowball.
Imagine the following example. We have eight outstanding loans, as follows:
- Mortgage. Amount outstanding £80,000. Interest rate 5.2%. Minimum monthly payment £680
- Student loan. Amount outstanding £9,000. Interest rate 3.1%. Minimum monthly payment £61
- Car loan. Amount outstanding £14,000. Interest rate 14.9%. Minimum monthly payment £114
- Financing for furniture. Amount outstanding $799. Interest rate 1.5%. Minimum monthly payment £23
- Credit card 1. Amount outstanding £4,320. Interest rate 18.9%. Minimum monthly payment £72
- Credit card 2. Amount outstanding £1,400. Interest rate 7.9%. Minimum monthly payment £10
- Store card 1. Amount outstanding £1,500. Interest rate 27.0%. Minimum monthly payment £35
- Store card 2. Amount outstanding £500. Interest rate 12.5%. Minimum monthly payment £6
Total minimum payments total £1,001. After performing our fictional monthly budget, we have determined that we have £1,150 each month to pay against all our debts (ie an over-payment of £149 per month). For the purposes of this example, this is expected to stay consistent for the life of the loans.
Firstly, let’s look at snowball repayment.
This method would pay down the debt based on the smallest balance, starting with Store Card 2, followed by financing for furniture, etc etc.
Our loans have been entered as follows:
Our repayment of each individual loan is then detailed:
This tells us that in total, we pay approximately £54,000 in interest and become entirely debt free by May 2025.
So, our total interest paid is approximately £44,750 and we pay our debt in September 2014.
So, in our realistic example above, we have the following split as a result of our debt repayment:
Wow! Our monthly payments do not alter between the two methods. However, we have saved a remarkable £9,221.70 simply by changing how we pay off our loans.
The only argument for the snowball method is a psychological one. However, in this example, surely almost £10,000 of additional savings is a much better incentive than simply being able to cross one debt amount off a list!
Debt repayment, our attitude towards debt and understanding of wealth creation is further detailed in my book, Becoming Rich: one step at a time, available now in the Amazon e-book store.