There’s a chill in the air, and as much as I don’t want to admit it, this midwesterner knows that winter is coming. Although I’m looking forward to curling up by a fire with a book about finances (yes, I actually do this!) and dreaming less about pennies from heaven and more about snow angels, the idea of snow also makes me think about debt and the best way to pay it off: Debt Snowball or Debt Avalanche?

Debt Snowball

No, this isn’t something that you throw at your bill collectors! The Debt Snowball is a method of paying off debt where you pay the minimum payments on all your debts and put all of your extra money into the debt with the smallest balance until it’s paid off. After that debt is paid off, you put the money you were using as its minimum payment and all your extra money toward the debt that now has the lowest balance. You continue with the method until all of your debts are paid off. The idea behind the “snowball” method is that when you pay off a debt, you have more and more money to put toward the other debts as the minimum payments disappear, kind of like a snowball that gets bigger and bigger as you roll it through the snow!

Here’s how it would work. Say George has the following debts and minimum payments:

If George has $1,000 per month to pay off this debts, where would he put the money?

First, George would pay all of the minimum payments on his debts, which would equal $675. With the extra $325 each month, under the Debt Snowball method, he would:

1. Put all of the $325 into the lowest balance debt, which would be his $3,000 Lower Interest Credit Card.
2. Once that debt was paid off, he would put the $325 plus the $75 minimum payment that has now been eliminated toward the next lowest balance debt, meaning he’d be putting $400 extra toward his $5,000 Car Loan.
3. After the Car Loan was paid off, he would put the $400 plus the eliminated $125 minimum payment toward his $7,000 High Interest Credit Card balance.
4. Once that was paid off, he would put $525 plus the eliminated $200 minimum payment toward either of his Student Loans since they have the same balance. It would make the most sense to work on paying off the Private Student Loan first because it has a higher interest rate and higher minimum payment.
5. Using this method, George will have his debt paid off in 3 years 7 months and pay a total of $7,679 in interest.

The Debt Snowball method only looks at debt balances, not interest rates, in determining which debts to put your extra money toward. Because it doesn’t look at interest rates, it could mean that you end up paying more in interest than you would using the Debt Avalanche method discussed below. However, there are other benefits, which is why it is often recommended. One of the big benefits for many people is psychological. If you have small debts, you will get to see yourself paying off your first debt quickly, which gives you a sense of accomplishment and boosts your confidence in your ability to pay off all your debt!

The Debt Snowball method can be good for you if:

• You have many debts with various balances and similar interest rates;
• You are worried you’ll have a hard time sticking with a debt repayment plan and need some instant (or quicker) gratification of getting rid of a debt to boost your confidence in your ability to pay off all your debts;
• You hate having to pay lots of different debts every month and want to get the number of payments down;
• You would like to have the extra cash flow from getting rid of many minimum payments so you can focus on bigger debts.

Debt Avalanche

Sadly, again, this method doesn’t involve covering your debt collectors in piles of snow. The Debt Avalanche is a method of paying off debt where you pay the minimum payments on all your debts and put all of your extra money into the debt with the highest interest rate until it’s paid off. After that debt is paid off, you put the money you were using as its minimum payment and all your extra money toward the debt that now has the highest interest rate.

As you can see, this method doesn’t sound so different than the Debt Snowball. It is very much the same concept of putting all your additional money into one debt until it’s paid off and then using the eliminated monthly minimum payments to focus on a new debt. The focus is just on the highest interest rate instead of the lowest balance. The reason for this is that in the end, you’ll pay the least amount of interest by eliminating the highest interest rate debts first.

Here’s how the Debt Avalanche would work. Say George has the same debts and minimum payments:

If George has $1,000 per month to pay off this debts, where would he put the money?

Just like in the Debt Snowball, George would pay all of the minimum payments on his debts, which would equal $675. With the extra $325 each month, under the Debt Avalanche method, he would:

1. Put all of the $325 into the highest interest rate debt, which would be his 24.0% interest High Interest Credit Card.
2. Once that debt was paid off, he would put the $325 plus the $200 minimum payment that has now been eliminated toward the next highest interest rate debt, meaning he’d be putting $525 extra toward his 14.5% interest Lower Interest Credit Card.
3. After the credit cards were paid off, he would put the $525 plus the eliminated $75 minimum payment toward his 8.0% interest Private Student Loan balance.
4. Once that was paid off, he would put $600 plus the eliminated $150 minimum payment toward his 5.0% interest Government Student Loan balance.
5. Finally he would put the $750 plus the eliminated $125 minimum payment toward his 2.5% interest Car Loan.
6. Using this method, George will have his debt paid off in 3 years 7 months and pay a total of $7,093 in interest, a savings of $586 compared to the snowball method.

As you can see, the order of the debt payoffs is very different in this method, with one of the lowest balance debts coming last in the list of repayments, after paying off much higher debt balances.

The Debt Avalanche method can be good for you if:

• You have many debts with various balances and varying interest rates;
• You want to get rid of your debt by paying the least amount in interest.

You may have noticed that in the Debt Avalanche method, due to the fact George would be paying minimum payments all along on his Car Loan, the balance would be very small while he was still paying off his other debts. It may be tempting for many people to just pay off that balance because its small instead of putting their money into the higher interest rate debts. While that might not technically be the most cost effective method, psychologically that may be the best choice for you!

You also may have noticed that in this scenario, choosing the Debt Snowball versus the Debt Avalanche doesn’t change the amount of time it takes to pay off all of George’s debt. But, the Debt Avalanche does save almost $600, and who doesn’t like saving money?! But it shows that you really need to calculate the differences, because sometimes the savings using the Debt Avalanche might not make up for the psychological benefits of using the Debt Snowball and seeing your accomplishments early on.

 

Other Considerations

• You don’t necessarily have to choose only one method. If you have a few small debts, you can pay those off quickly to gain some momentum, empowerment, and cash flow from getting rid of the minimum payments and then switch to the Debt Avalanche method and focus on the higher interest rate debts. Or like the example above, you could use the Debt Avalanche but pay off lower interest rate debts first once the balances are very low.
• Know yourself. If paying off one big high interest rate debt and letting small lower interest rate debts sit there with minimum payments will drive you crazy or get you off track from your plan, opt for the Debt Snowball or a combination of approaches.
• Do the calculations for your particular debts. You may find that there isn’t a huge cost difference between the two methods, so whichever one will make you more likely to stick to your plan will make the most cents (pun intended)!

We love to hear your debt payoff stories! Let us know what method has worked best for you in the comments below!