Debt snowball and debt avalanche are two popular methods of debt repayment involving prioritisation.
Let’s begin with an explanation of debt snowball. I used the snowball method when paying off my own debts in 2014. To explain it simply, for debt snowball you will list down all your debts except for the mortgage, from the smallest to largest. Disregard the interest rates, you are only interested in the totals owed. For ease of understanding, here is an example of how that might look like for somebody with a financial life more complex than my own.
Furniture loan: £450
Credit card: £1355
Car loan: £3787
Student loan: £17,900
As part of your budget, you will also note down the minimum payments you must make on each of the debts and also calculate how much money on top of the minimum payments you can commit to paying the debt off every month. Let’s say that you have £500 available every month to throw at your debt and your minimum payments look like this:
|Loan||Total owed||Minimum payment|
Because we don’t care about the interest rate, you will simply start by paying all your minimum payments and then putting the £500 towards the furniture loan (and clearing it) and the credit card. At your next pay period you will take the £500 AND the £22.50 minimum payment from the loan you killed and put both towards the next one on the list, the credit card, and so on.
The key benefit of this method is that it shows you your progress quickly. This in turn is a good motivation to keep going.
The key drawback of the method is that it disregards the interest rate of your debts and if your bigger debts are charged at high annual interest, it will cost you more to repay them in the long run. The repayment time and total paid would look approximately like this:
|Loan||Total owed||Minimum payment||Interest rate||No of months to repay||Interest paid*|
*Let’s assume that the interest does not capitalise.
By using the snowball method you would end up paying your debts off over 27 months and shelling out £2051.96 in interest on your £23,650 loans.
Debt avalanche focuses on the interest rates and is the less emotional and more mathematically correct method.
Your process will initially be similar to debt snowball, where you note down all your debts. However, instead of focusing on balance, you will first focus on the interest rate and prioritise from the highest to lowest. Using the same example set of loans as in the snowball method, here is how the avalanche version of the list would look like:
|Loan||Interest rate||Total owed||Minimum payment|
The idea with debt avalanche is to tackle the loans which cost you the most first in order to cut those costs down and save you on the interest.
With the same assumption of £500 available in the budget and the interest not capitalising, here is how the avalanche maths would look like:
|Loan||Interest rate||Total owed||Minimum payment||No of months to repay||Interest paid|
In this scenario using debt avalanche would result in the debt cleared one month faster and with a £690.80 saving on interest. However, you would see actual progress only in month 3 with the card loan falling off the list. The biggest drawback of the avalanche method is that despite being financially sane, it does rely on the ability of a person to stay motivated even when the results take a while to show.
During my own debt repayment journey I opted for the snowball method because I needed something to keep me going – feeling the progress did just that. If you are more methodical than me, avalanche might be more suitable.
Both methods have their firm fans but ultimately the goal for both is simple – pay your consumer debts off so that you can start aiming towards building wealth.
The next post will explain the basics of starting a budget – I will throw in a couple of principles which might help you with setting a realistic budget and defining basic financial goals.