There are many tools that can help us get out of debt. A good budgeting tool can help us manage our money. Credit and debit cards can help us track our spending. Even monitoring our credit score can help us lower the interest on existing debt. And then there is the debt snowball.
The debt snowball, and its supercharged better half, the debt avalanche, are powerful tools to eliminate debt. In this guide we’ll walk through the debt snowball and how it can help anybody get out of debt.
The Basic Debt Snowball Method
To understand how the debt snowball method works, let's look at a simple example. We'll assume that a recent graduate has one car loan and two student loans with the following terms:
- Car Loan: $20,000 at 6% with a monthly minimum payment of $400;
- Student Loan 1: $10,000 at 6.8% with a monthly minimum payment of $115;
- Student Loan 2: $5,000 at 6.8% with a monthly minimum payment of $60.
The total monthly minimum payment is $575. As the minimum payment is made from month to month, the loan balances will of course go down. Eventually the second student loan will be paid off, reducing the total monthly minimum payment by $60. It’s here that the debt snowball method kicks in.
Rather than continue to pay the minimum monthly payments on the remaining two loans, the recent graduate continues to pay the same amount they did before–$575 (or even more if they have the financial resources to do so). Instead of applying $60 of that payment to the second student loan, they instead apply it to one of the others (we'll worry about which one in a minute). When the second loan is paid off, the entire $575 will go to the third and final loan–in this case the car loan.
By continuing to pay $575 a month until all three loans are paid off, our college graduate enjoys two benefits. First, it significantly decreased the time it took to get out of debt. Second, it reduced the total interest paid. In fact, using the debt snowball in this example would save over $1,000 in interest.
All of this raises a question we've avoided until now. How do you decide which debt to apply the extra payments?
Debt Snowball vs. Debt Avalanche
There are two schools of thought. The first, the debt snowball method, argues that any extra cash should go to the debt with the smallest balance. In our example, once the $5,000 student loan was paid in full, the $60 would then be applied to the $10,000 loan.
The theory is that paying off a loan quickly will help motivate people to stay the course. Dave Ramsey is an advocate of the debt snowball approach.
The second approach is called the debt avalanche. Unlike the debt snowball, with the avalanche you apply any extra money to the debt with the highest interest rate. By taking this approach, it may take longer to pay off the first debt. The upside is that you'll pay less in interest and become debt free sooner (thus the name avalanche).
So which approach is best? This depends on several factors, including the specific terms of your debt. In the example above, both approaches have the same result. That's because the loans with the smallest balances had the highest interest rate. Where the larger loans have much higher rates, however, the debt avalanche method can save thousands of dollars in interest.
Believe it or not, the debate between the debt snowball and avalanche methods is hotly contested among personal finance gurus. This is in large part due to Dave Ramsey's insistence that paying the smallest debt first is the best option regardless of interest rates. Those more inclined to mathematics beg to differ.
One thing the debate often neglects, however, is the importance of liquidity. When you pay extra on an installment loan such as a car loan, you can't get the money back. It lowers your balance, but you can’t ask to borrow it again.
In contrast, with a credit card, line of credit, or other revolving debt, you have the option of borrowing against the line of credit after you've paid down the balance. Why is this important?
It gives you flexibility. When my wife and I were paying off our debt, we kept a very small emergency fund. Rather than tying up our money in a savings account, we put it toward our debt. Because we had access to credit cards and a home equity line of credit, we knew we could handle an emergency.
Debt Payoff Plan
It's easy to get hung up on which debt to tackle first. While it's an important question, it's only one piece of the puzzle. Getting out of debt involves a lot more than just the debt snowball or avalanche methods. In fact, there are three critical challenges to tackle. Choosing which debts take priority is the third and final decision that must be made. The first two are more important.
First, it's critical to avoid new debt. While it's as obvious as avoiding junk food if you want to lose weight, it's the hardest part of attaining freedom from debt.
Second, and this is critical, debts should be refinanced to the lowest possible interest rates. Credit card debt should be refinanced to 0% APR credit cards. School loans should be refinanced when feasible using any of several options.
If all debt has been refinanced to low rates, the debt snowball versus avalanche debate fades into the background. If one or more high rate, high balance debts remain, however, the debt avalanche approach to debt repayment can save a bundle.