An avalanche beats a snowball

There are two main methods of eliminating debt: the snowball method and the avalanche method. So let’s agree on a new debt-relief strategy, shall we?

Who wouldn’t want to be totally debt-free? The problem is that for most people it’s a pipe dream. That’s because after covering the costs of living, raising a family, sending the kids to university or college and saving for retirement, there simply isn’t enough money left to pay off debt.

So let’s agree on a new strategy, shall we? Let’s try to eliminate some debt, the bad kind, and not worry so much about our good debt.

Good debt is debt that is used to acquire assets that are likely to appreciate. It is also likely to be instalment debt, where each payment covers both interest and a portion of the principal. If you stick to the payment plan, the debt will automatically be paid off at the end of the term or amortization period. Because of the fact that good debt is usually secured by an asset, the interest rate on it is probably the lowest it will be on any debt you can have. A reasonable mortgage on your principal residence is an example of good debt.

Bad debt is debt that is used to pay for things that you don’t really need and is usually revolving debt as opposed to instalment debt. That means all you have to do is pay the interest, or a low minimum payment, each month, and nothing toward the principal. It can sometimes be at a low rate (a home equity line of credit) and sometimes at a high rate (credit card debt). Since none of the minimum payment goes to pay down the loan balance, the debt frequently never gets paid off.

There are two main methods of eliminating debt: the snowball method and the avalanche method.

SNOWBALL METHOD

Under this setup, you list all your debts, starting with the smallest outstanding balance down to the largest. For each debt enter the name of the debt, the balance owing, the minimum payment required and the interest rate. Make only the minimum payment on all the debts except the first one on the list. Allocate all excess cash to the first debt on the list until it is paid off. Once it is paid off, move debt No. 2 to the No. 1 position, and maximize the payments on it until it is paid off. Move on down the list until all debts are paid off.

AVALANCHE METHOD

With this scheme, you rank your debts by starting with the one with the highest interest rate, not the smallest balance. Minimize the payments on all debts except the first debt and maximize the payments on the one that is costing the most.

Which method is best? From a purely mathematical point of view the avalanche method wins. You’ll pay the least amount of interest and pay the debt off faster.

The problem is if the debt with the highest interest rate is also the largest debt, it might take many years to pay it off. People tend to give up, as there never seems to be any progress. That is why many people tend to favour the snowball method. The motivational benefit of a quick win, paying off even a small debt, can give people the boost needed to continue with the debt-reduction strategy.

Note that you may get lucky. If your smallest debt also has the highest interest rate, both methods start with the same debt so you don’t have to choose. And of course both methods assume there is no additional debt being added to the balance.

There is a great free website that has a calculator where you can track your progress on up to 20 debts to compare both methods (go to http://www.whatsthecost.com/snowball.aspx?- country=us).

Say we have $10,000 in credit card debt at 20% interest with a $50 minimum payment and an $8,000 line of credit at 5% interest requiring minimum payments of $100. Assume we have $500 per month to allocate to our debt payments. I entered this information in the calculator and here are the results. Using the avalanche method it would take 44 months to pay off these debts. The first debt, the credit card, would take 32 months to pay off. The interest costs over this time would be $3,802. The snowball method would take 51 months to clear the debts, with total interest costs of $7,139, an additional cost of $3,337. The second debt, the line of credit, would be gone in 19 months, 13 months less than it would take to pay off the credit card under the avalanche method.

So if you are disciplined, the avalanche method is often the clear winner. If not, start making snowballs.