Debt consolidation and repayment takes up a lot of America’s bandwidth. You can’t watch TV, especially daytime TV, without seeing at least one advertisement promising you freedom from debt – call now! These gimmicks are hit-and-usually-miss, but the sheer ubiquity of this conversation tells us it’s on everyone’s mind.
Debt, like every other financial issue, is emotional at its root. Salary, bank account size, credit score – these are all emotional issues, sensitive and sometimes painful. But debt is a nerve center. It connects to our family baggage, our psychological frailty and is a constant reminder of our financial limits.
This relegates debt repayment to the not-fun-to-talk-about category – but it can become much more expensive as an afterthought. With that in mind, let’s look at two important debt reduction plans, realizing it has as much to do with our emotional makeup as it does with figures on a spreadsheet.
Let’s look at two popular approaches: snowball and avalanche.
Debt Repayment Method No. 1: The Snowball Approach
This debt reduction plan has been most popularized by the one and only Dave Ramsey, whose faith-based approach to personal finance is incredibly popular. As confidently as they are presented, his methods are not without flaws, and the snowball debt repayment approach is something we should think through before implementing.
The basics are simple: The person pays the minimum balance on each debt they have, and then adds any leftover money to the smallest debt in the row. After you pay off your smallest debt first, you then move on to the next and the next – a snowball effect. This approach is taken without regard to the interest rates or timelines on each debt.
Let’s break this down. Dennis Debt-Payer has the following debts outstanding:
- Car: $8,000
- Credit Card: $10,000
- Student Loan: $30,000
- Harley: $4,500
He probably shouldn’t have bought the bike, but he fell in love with it and he de-stresses from the week by burning up the highway. Dennis finds himself in a good-enough job and decides, for his 40th birthday, that he will buckle down about the debt in his life.
Using the snowball method, he starts with the motorcycle debt. Dennis has to maintain his minimum payments on all his debts, let’s look at those:
- Car: $150
- Student Loan: $200
- Harley: $100
- Credit Card: $250
So, Dennis is looking at $700 bare minimum in debt payments he has to make every month. Using the snowball method, he makes the minimum payments on everything to keep current. After all his bills are paid, Dennis has $400 to make use of, so he puts it toward the Harley debt, too.
Nine months later, Dennis rides his hog to the post office carrying his last check for his last payment on his motorcycle loan. Flush with satisfaction, he narrows his list of debts and starts putting that newly freed-up $500 a month toward his car, which is now the smallest debt he owes.
On the Harley payment, he paid $4,577 in all, ending up paying $77 in interest. One of the drawbacks here, for the credit card especially, is that the larger debts continue to collect interest through the process.
Debt Repayment Method No. 2: The Avalanche
Let’s rewind Dennis Debt-Payer and have him start with an entirely different debt repayment plan.
This approach, called the avalanche method, starts with the highest interest rate loan, which for Dennis looks like this:
- Credit Card: 19%
- Car: 5%
- Harley: 4%
- Student Loan: 3.5%
Again, he pays the minimum amounts on everything, to keep the creditors at bay, but this time, he sets his sights on paying down his credit card debt with available money. The idea is to pay off the most expensive debt first, and once that falls then the next (car loan) and so the debt rolls down like an avalanche.
In our first scenario, Dennis rode in triumph to the bank on his newly paid-off Harley in a mere nine months. Under the avalanche plan, it takes him over twice as long (about 18 months) to pay off his credit card, and he’ll still owe on everything else.
However, in the long run, Dennis’s debt costs him a lot less under the avalanche method. The interest rate on a credit card is almost always the highest of any kind of personal debt and so becomes the most expensive in a short period of time. The avalanche addresses that issue first, and saves him money in the long run.
So Which Debt Repayment Method is Better: Snowball or Avalanche?
On paper, with simple math in front of you, the avalanche method seems like the obvious choice. If Dennis went with the snowball method, in 18 months or so he will pay roughly $4,000 interest on $10,000 credit card debt – a lot of money but not as much money if he delayed repayment.
But the psychology behind the approach is where the debate lies. The snowball method may be preferable because it provides the emotionally powerful “quick win.” Driving around on a paid-for motorcycle might give you just the inspiration you need to tackle the next debt. If that debt is gone in six months or a year, your motivation “snowballs” until you are debt-free.
The avalanche method has math in its favor but is taxing mentally. Sure, you may chip away at that high-interest debt, but if it takes years to get rid of, that might not inspire you. You might be tempted to start taking financial “cheat days,” spending money unwisely because your debt repayment plan seems to have little effect and your goal still seems so far away.
Know Thyself
It’s a matter of knowing yourself: What motivates you?
If you “avalanche” your debt, will you rack up more of it during the time it takes to pay off or will you stay motivated when the finish line seems so far away?
If you “snowball” your debt, will a high-interest loan end up costing you more over time or will you ultimately be better off because you stay motivated to continue paying down what you owe?
Your goal is to be debt-free, and you need to choose the method that will work for you – right now, and especially a year from now.
Your advisor knows not only the models for debt-repayment, they know you, which is crucial in the journey toward debt freedom. Get in touch today, and let’s take the first step.