When it comes to debt the best thing in most cases is to pay it off as quickly as possible so that your progress towards financial independence isn't delayed. After all, you don't want the interest on your debt to build up and eventually become a huge problem that could've been dealt with early; see my previous post on how small debts can be much bigger than you realise if you let them get out of control.
In this article I want compare two popular debt repayment strategies, Debt Avalanche and Debt Snowball, to see how each one works and to see if the advantages of each are always applicable. Ultimately I want to show that actually, the comparison between the two strategies is the wrong thing when it comes to handling your debt.
In both debt repayment strategies you will be making the minimum payments on all of your debts but you will handle any extra payments with your remaining money differently.
With Debt Avalanche you will focus on putting your remaining money towards your debts with the highest interest rate in order to clear that off first. Once that is done you will then focus any remaining money you have on the debt with the next highest interest rate, and this will continue until you become debt free.
Debt Snowball approaches things slightly differently by having you focus your remaining money on your debts with the smallest balance first so that you can get them out of the way as quickly as possible. After each debt is cleared you move onto the next debt with the next smallest balance and build your way up to the final largest debt.
So why pick one approach over the other?
Here's a diagram to compare the two different strategies:
The Debt Avalanche strategy will usually result in a lower amount being paid towards debt overall as you are focusing on higher interest payments first, meaning the interest has less opportunity to build up while you're making repayments.
However, the Debt Snowball strategy may let you clear away some of your debts completely in a shorter amount of time, leaving you with just a handful of your biggest debts to focus on. It may cost you a bit more overall but it is much easier to focus on one or two debts instead of trying to manage four or five.
These are generally the differences that you will hear or read about when it comes to comparing the two strategies, but they are general guidelines only and it's entirely possible for things to sometimes play out a little bit differently compared to what is usually expected.
So I wanted to work through some examples to show how that might be the case.
First things first, when it comes to clearing your debt you need to start by finding out what your exact position is. You can do this with the following pieces of information:
What are all your debts and how much do you owe on each
What is the interest rate being applied each month to each debt
What is the minimum monthly payment of each debt
Without this information it would be extremely difficult, if not impossible, to come up with any sort of strategy because if you don't even know what situation you are in then how are you supposed to do what you need to do to solve it. So that's where you have to start.
In the example for this article let's imagine you have done that information gathering and you are in the following debts:
This amounts to £26,400 in total debt with a total monthly minimum payment of £740.77. Not a small amount by any means, but you're going to be fine because you're facing up to the problem instead of running away from it.
In fact, let's say you're going to put all of your efforts into clearing down your debts (as you should) and that means you'll put an extra £100 each month towards your debt payments. Bringing your total monthly payments to £840.77.
Now let's see how each strategy plays out and if it stays true to the general expectations that were laid out earlier.
As a quick reminder, the Debt Avalanche strategy focuses any extra money towards paying off debt with the highest interest rate after making the minimum payments on all debts. When one debt is paid off you will then focus the money that would have gone into the first debt (now paid off) plus any extra money towards the debt with the next highest interest rate. This keeps going until all of the debts are cleared and this usually results in less money being paid towards interest overall.
Based on the debt table above and the extra £100 a month payment this is how your debt payment structure looks at the start:
As your personal loan is the debt with the highest interest rate, 20.9% each year or 1.741% each month, your extra £100 payment will go towards that debt first. Once the personal loan has been cleared down it means you will have £412.14 freed up each month to go towards the next debt, which would be your credit card debt as it has the next highest interest rate. Finally, once the credit card debt is cleared you will put all of your money into paying your car finance loan. At that point you would be paying the full £840.77 each month into that debt.
Here is a summary of how your payments will go until all your debts are cleared:
To explain what this table is telling you, the first row after the header shows how many months in total it takes to pay each debt off in full. This is including all of the monthly interest that is being added to the remaining balance at the end of each month.
The starting balance is what you borrowed, and therefore the principle that you need to pay back before interest is applied.
Payments made are the different payments you made each month towards the debt, and how that payment changes as time progresses and a debt is cleared. For example, you make payments of £90.00 towards your credit card debt for 25 months before making a payment of £410.27 for 1 month; this extra money is available because you managed to clear off your personal loan debt in the 26th month after making one last payment of £91.87.
After you tally up all of the monthly payments you will arrive at the total amount paid back for each debt, which then allows you to calculate how much you paid in interest overall.
With this information known we can say that the Debt Avalanche strategy allows you to clear your debts in a total of 35 months and you pay £4,331.46 in interest on top of what you borrowed.
With the Debt Snowball you also make the minimum monthly payments on all debts, but you will use any remaining money to pay off the debt with the smallest balance. Note, not the smallest interest rate. When that debt is paid off, the money that would’ve gone into paying that debt is paid into the debt with the next smallest balance, until you make it through all the debts and clear them.
By targeting the smallest balance first you might be able to get some quick results by clearing some debts early on in your journey towards debt freedom. This can give you a motivation boost, and by the time you get to the last debt you will be paying off large amounts each month as all of your monthly payments will have rolled up into one big snowball.
The starting debt situation will be the same as the debt avalanche strategy, so that we can compare the results at the end. Using the Debt Snowball strategy this is how your debt payment structure looks at the start:
As your credit card debt is the debt with the lowest balance you will make the extra £100 payment towards that debt first. After you have paid off your credit card you will have £190 freed up to pay the next smallest debt.
Based on the numbers at the start it appears as though the next smallest debt will be the personal loan, but don’t overlook its interest rate. The high interest rate might mean the personal loan can overtake another debt in size during the time it takes you to pay off your credit card.
Regardless of which debt is the next smallest when the credit card is paid off, the extra £190 will be paid into it. Finally once you are down to your last debt you will have snowballed your payments up to £840.77 each month.
Immediately you can tell some of the differences between both strategies. With this Debt Snowball strategy you will be focusing first on your credit card debt instead of your personal loan. It will be interesting to see how that changes the final results, allowing you to compare and contrast to make a decision on which strategy suits your situation the best.
Here is a summary of how your payments will go until all your debts are cleared:
The method to read this table is exactly the same as in the first example.
The key things to note in this table is that it also takes a total of 35 months to pay off all debts, but it takes 30 months to fully clear the first debt. This is an interesting result considering that the Debt Snowball typically claims to give you quicker results in terms of clearing away the smaller debts.
After tallying up all the payments you can also see that a total of £4,432.28 interest is paid on top of what you borrowed. This is £100.82 more than the first example meaning that the Debt Snowball strategy is both slower in terms of getting rid of the first debt, and more costly when it comes to the overall amount paid back.
So it's settled?
So does that settle the debate between these two strategies?
Well the results shown above are only applicable to the set of figures used in the example above and in this case it does appear that the Debt Avalanche approach is a better choice. However, the result can easily be different based on another set of numbers, or even if the debts were the same but the monthly payment amounts were different.
But here's one thing to point out, both approaches took the same amount of time overall and the difference was only £100.82 at the end. Again, this is specific to the example but to me this suggests that it doesn't matter too much which strategy you go with when you consider the big picture. £100.82 over 35 months means you paid an extra £2.88 each month, or like £0.10 a day; obviously if you can choose not to pay it then that would be better but that's the scale we're dealing with here.
It would be interesting to play around with the figures in the example a bit more, perhaps by changing the minimum payments or extra payment, to see if the results turn out in a similar fashion. Even more interesting would be to take some example debts from other articles that debate the Debt Avalanche vs. Debt Snowball strategies to see what happens.
Often the articles have a clear preference or hide away some of the detailed workings so it's hard to really know which is actually better or if there isn't that big of a difference overall. I'd like to try and get to the bottom of that and give a clearer view to people out there in some future articles.
But here's what I can say at this point; by looking at both strategies and working through the numbers you are able to give yourself a much better chance in the long run when it comes to tackling your debts. Too many people try to get out of debt by blindly making payments based on the statements and bills coming in each month. Yes, you need to make your payments, but without really understanding the overall picture it's no wonder so many people fall off track or lose motivation.
Always get a good understanding of the overall picture by gathering the information that I mentioned earlier in this article. With knowledge on your side you will be able to figure out how things will play out over time, allowing you to formulate a strategy that you yourself can understand and follow; and that is actually the key factor in deciding which strategy wins in the long run.
Debt management is about more than just money; it's also very much about your own psychology. Therefore, if you're only playing one half of the game then it's easy to lose.
This has never been about Debt Snowball vs. Debt Avalanche; it's always been about You vs. Your Debt.