So, what is the best way to pay off debt? It is one of the most asked questions to financial experts.
Should you save for an emergency or pay off debt first? Is there such a thing as “good” debt? Should you pay off small amounts first, or those with high interest rates? Or in other words: debt snowball vs. debt avalanche.
Debt Snowball vs. Debt Avalanche
You need a plan when it comes time to pay off debt. If you just start throwing a bit extra at debts at random, you’ll likely fail or just not stick to the non-existent plan. It is best to pay off your debt with a real plan.
Debt snowballs and avalanches are both methods for paying off debt.
Dave Ramsey is known for making the debt snowball method so popular. Debt snowball is simple, you start paying off your debts with the smallest balance first. Make all your monthly minimum payments. Then throw any extra funds at that smallest debt balance.
Once that debt is paid off, continue paying the previous minimum payment amount, but put it toward the next-to-smallest balance debt. Each new debt you pay off then essentially rolls into the next one. In this way, you “snowball” your minimum payments, putting more money toward your debts each month until they’re all paid off.
The debt avalanche is similar in that you roll your minimum payments together as you pay off debts. Where it differs is in the order in which you pay off your debts. Instead of starting with the smallest balance, the debt avalanche has you start with the highest-interest debt or the largest, causing an "avalanche". Rank your debts by interest rate, and then pay them off in reverse order, following the same “rolling” method as the debt snowball.
What is the Difference?
Ultimately, your choice betweens the two debts comes down to two things: math and psychology. With math, the debt avalanche always wins. But with psychology, the debt snowball usually does. People often feel better using the snowball method, because it seems easier to tackle. They see results by tackling the smallest debt first. However, the avalanche will save you money.
The Math Behind the Avalanche
If you know much about compounding interest, the mathematically correct way to pay off debts should be obvious to you. Knock out your highest interest rates first and you’ll save money over the long haul.
And this is true. In some instances, the difference could be hundreds or thousands of dollars in interest. You can use an online debt calculator to run the numbers. It’ll show you just how much you’ll save by using a debt avalanche rather than a debt snowball.
The Psychology Behind the Snowball
Findings show that the snowball method is more likely to work. One study from Harvard showed that focusing on one debt at a time and knocking out the smallest debt is the best approach. Another study from the Kellogg School of Business concurred. Essentially, consumers who start debt payoff with the smallest debt are more likely to be successful in their debt payoff efforts.
So Which Is Better?
Neither approach is considered better than the other. It is a personal choice.
If you’re motivated by math—as many people are—you may find the debt avalanche is a better fit. If you’re like most consumers, though, the debt snowball is more likely to keep you on track.
The longer it takes to pay off your debts, in general, and the wider the spread between your highest and lowest interest debts, the more you’ll save with the avalanche.
You might consider paying it off super high interest rates first and then paying off your debts in order of balance and get the benefits of both methods. Or you might get some momentum by paying off debts first, and then pay off your higher interest rate accounts.
The best option is to choose a plan and try it, then adjust it needed to make sure you stick to your plan.