Debt Snowball vs Avalanche
If debt repayments are putting pressure on your cash flows, then you need a plan to de-debt yourself and improve your expense structure. In order to do so, you will have to come up with a plan to start paying-off a majority of the outstanding debt that you currently have. If you are reading this, then chances are that you probably cannot simply repay all the debt in one go. You may be struggling to even keep up with the monthly payments.
So, what can you do to get out of debt? If your debt hasn’t gone to uncontrollable levels, then there are two well-known DIY methods that you can consider. They are called debt snowball and debt avalanche.
Let’s learn more about each of these debt reduction strategies below!
What is the debt snowball strategy?
Think of the snowball effect where you roll a small palm-sized snowball down a hill covered with snow. As the ball rolls down, it picks up more and more snow until it gradually turns into a massive snow boulder. The snowball theory is based on momentum and how it can be gradually built up to create a large force.
Now apply the same principle to debt repayments. Keep paying all the monthly installments on your debt as you have been doing. Additionally, try to save up some money or create some extra income to make extra payments on your smallest debt. Gradually, with the extra money, you will pay off your smallest debt.
Then, you do the same with the next smallest debt, using the extra cash from your savings to start paying off the next smallest debt. After a while, you will pay off your second smallest debt. Then, you continue the same process with the third smallest debt and so on.
You started small, but over time, you managed to gather momentum and started paying off larger and larger debts. You eventually would pay off all your debt.
An example of debt snowball
Let us assume that you currently have three debts:
- $1,000 of credit card debt with a monthly repayment of $30
- $5,000 of an auto loan with a monthly repayment of $150
- $10,000 of a student loan with a monthly repayment of $300
So, your monthly outflow is the sum of $30, $150, and $300, which equals $480. In order to deleverage yourself, you try and find $50 of extra income or save $50 more than you normally would.
Now, you use that $50 to pay off the $1000 credit card debt. Once that loan is closed out, you have $50 of extra cash plus the money you save by not paying the $30 of credit card monthly payment.
You then use the $80 for the next few months to pay off the auto loan. Then you continue the same and eventually get rid of your student loan as well. This is called the debt snowball method of getting out of debt.
What is debt avalanche?
An avalanche is more abrupt than a snowball. It occurs when a substantial piece of snow falls because of a weaker layer underneath the large piece fractures and breaks. Gravity makes the large piece of snow move down quickly and become larger as it rolls down the hill.
Debt avalanche is also based on scale. It involves tackling the largest piece and then building momentum with time.
In the debt avalanche method, you continue to make monthly payments on all of your debts. However, as was the case with the debt snowball method, you try to raise extra cash through savings or additional income.
You then use that extra cash to first pay off the debt with the highest interest rate. When that debt is paid off, you then move on to the debt with the second-highest interest rate. You pay that off and continue the process till all your outstanding debt is paid off.
The debt avalanche method is preferred by those borrowers who want to pay lower cumulative interest on their loans. The overall interest cost in the debt avalanche method is lower because it involves tackling the most expensive debt first.
An example of debt avalanche
Let us assume that you have three outstanding loans:
- $1,000 of credit card debt with a 10% APR
- $5,000 of an auto loan with a 15% APR
- $10,000 of a student loan with an 8% APR
So, in this case, you will first use the extra cash to tackle the auto loan. It has the highest APR at 15% and is the most expensive debt.
The amount on the auto loan is higher than that on the credit card debt, but because it is more expensive, you pay it off first. You then move on to credit card debt, and then the student loan.
What are the key differences between the two methods?
The biggest difference is cost vs time. The debt snowball method can lead to the clearing your first debt much quicker than would be the case with debt avalanche. You will see your first win much quicker and that would boost your motivation levels for sure.
The debt avalanche method may end up taking more time because your highest interest debt may not be your smallest debt. So, you need more patience and perseverance with debt avalanche.
However, the interest cost with the debt avalanche method is much lower because you get rid of your most expensive debt first.
In the debt snowball method, your most expensive debt could be the last one that you clear and so you end up paying interest for a long time.
So which method is better?
If you talk about the total time taken to clear all the debts, then there may be some exceptions to these trends.
For example, there could be a scenario where the debt avalanche method helps you pay off your loan a few months before the debt snowball method does. It all depends on your debts, the APRs attached to them, and your cash flow levels.
Another factor to consider is your personality and your mental model.
Are you the type of person that can stick to a plan for a long time even if you do not see immediate results? Or are you someone who needs to see a win, even if it is a small one, to get further motivation to continue with a plan?
So, one method isn’t necessarily better than the other. Studies have also proven this observation. It just depends on what strategy best fits your financial situation and your goals.
Real Estate Investor Training Course
Ever wonder how some people buy lots of rental properties, fix and flips, and find retirement early in life through real estate investing? We show you step by step how to build your own real estate investing operation from scratch to earn extra income to support your family and the path to early retirement.
Learn Real Estate Investing in 10 Days
Learn the 10 basic steps to becoming a real estate investor by signing up for my free 10 day email course. Each day I'll send you the next lesson.