Strategies for getting out of debt: Debt Snowball Vs. Debt Avalanche

Simply stated, debt is what you get when your expenses surpass your income. In a previous article I elaborated on how only paying the minimum payments on your credit cards is a surefire way to find yourself locked into debt for a very long time. Getting out debt is certainly possible, but requires minimizing expenses or increasing your earnings, or better still, preferably both. If you want to pay off your debt in a certain period of time, the difference between the amount that you’ll earn in that period and the amount that you’ll spend needs to be big enough to cover the existing debt and the interest on it. The basic formula behind this concept is very straightforward: earnings – expenses ≥ debt + interest.

In practice this means that if you’re in debt, you will need a solid plan and personal discipline to get out it. The first thing that you’ll need to do is to remove your reliance on credit. Stop adding more debt by ceasing to use your credit cards ¹. Secondly, determine the maximum amount of money that you are comfortable with and can afford to put towards your debt each and every month. This number should be greater than the sum of all the minimum payments.

The mathematics and psychology of debt repayment

Unfortunately, having figured out the monthly repayment that you can afford doesn’t tell you anything regarding how you should go about repaying your debt. If you only have one credit card or loan then the math is much easier. You just need to pay back the whole amount on that card, preferably through some form of monthly direct debit (from your bank account), so that it’s automatically taken care of for you.

Realistically though, most people who are in debt have an outstanding balance on several credit cards and possibly some loans ² as well. How should they distribute the repayment money each month? Should they divide the monthly amount by the number of cards and repay each of them equally? Should they pay proportionally based on the amount due on each card?

The goal here is to minimize the total amount of interest fees that you’ll have to pay your creditors over time, therefore allowing you to get out of debt as quickly as possible. The answer to this problem is mathematical, and it’s not a matter of opinion. There’s no room for “I think my method is faster…” type of thoughts. Basic mathematics already provides us with the best possible order of payment, so as to minimize interest.

That said, getting out of debt is a long process which generally involves a great deal of emotional involvement. The method for getting out of debt is only successful if you stick with it. For this reason, some people feel that a slightly suboptimal strategy, from a mathematical standpoint, is still acceptable if the psychology involved makes it easier for the debtor to feel motivated and keep at it until the debt is extinguished.

Hence, there are two methods which are often recommended by financial experts and debt counselors: debt-snowball and debt-avalanche. Both are straightforward and easy to understand.

The Debt-Snowball method

The idea behind snowballing debt is that you should pay only the minimums on all of your credit cards, except for the card with the smallest balance. This card should receive all the remaining funds available for repayment. For example, if the total amount required to pay the minimum on all the other credit cards is $500, and your allotted over all monthly repayment budget is $1,500, then you should put $1,000 towards the card with the smallest balance. If you happen to receive a bonus or extra money that you intend to put towards the debt, this too should go towards the smallest balance. When the amount available is more than enough to bring the balance to zero, then any leftover funds should be put towards the second smallest card (the one with the smallest balance amongst the remaining debt carrying cards).

This method has the advantage of motivating you because you’ll quickly see the smallest card’s debt vanish. The downside is that it’s not the most efficient method, and as such you could end up paying more interests and being in debt for longer than strictly necessary. A great proponent of this method is the popular radio host Dave Ramsey.

The Debt-Avalanche method

The debt avalanche method is a variant of the snowball one ³, where instead of ordering the debt repayment from the smallest to the largest balance, the order is defined from the highest interest rate to the lowest. This method is the fastest and most efficient strategy for paying off your debt. The downside in this case, is that if the balance on the card with the highest APR is large, you may be paying off your debt for a very long time before being able to say, “cool, one less card to worry about”. Mathematically speaking, this is the winning strategy, though you’ll need to employ personal discipline here, so as to not get discouraged.

Which one is right for you?

To show you the difference between the two systems, I’m going to use an entirely fictitious scenario. Imagine that you have the following credit cards (for sake of simplicity, say that they all have a fixed minimum of $10 or the specified percentage minimum below, whichever is greater):

The total amount of debt is $24,000. Assuming that you had a monthly repayment budget of $1,500, the debt-snowball method would take 19 months to pay off the debt and incur $3,243 in interest. The debt-avalanche approach would take 18 months and end up costing you $2,717 in interest fees.

Debt-avalanche is the best way to go about things, because it’s both cheaper and faster. Supporters of the other method will point out that debt-snowballing will clear the outstanding balance from the two smallest cards in August and October 2008, respectively. Going the debt-avalanche route causes you to wait until May 2009 to see your first card paid off in its entirety. Debt-avalanche is a smarter choice if you are patient enough to see it through to the end (it’s the approach that I personally use). If you are inpatient, remember that an “immediate gratification” attitude is a huge contributing factor to consumer debt in the first place. Generally speaking, the debt-avalanche method is financially unbeatable, while debt-snowballing is emotionally gratifying, but economically not the most efficient option.

If you’d like to see these methods applied to your own specific situation, you can use the calculator available here. Whichever you choose, you’ll get out of debt reasonably fast. Just stick with it, as I’m doing, and you’ll be able to enjoy a debt free existence.

Footnotes

[1] The idea is to stop your reliance on credit. It’s possible to use a credit card as a debit card, by paying the amount that you spend back right away, but it’s a very risky approach which may lead you to incur further debt. Experts suggest that you cut up or place your credit cards in the freezer, so as to not be able to use them while out shopping.

[2] Exclude mortgage loans from the snowballing method. Consider them a fixed expense, like monthly rent payments would be. Also keep in mind the difference between open end and closed end loans. Open (aka flexible) loans are ones that allow you to deposit over-payments, so as to be able to pay off the balance owing faster. This type of loan can be viewed as a low interest credit card in your strategy, given that you can pay back as much as you want (or more accurately, are able to).

[3] This is also known as Laddering, while debt snowballing is known as Reverse-Laddering.

Disclaimer: I’m not a financial adviser, just a guy who has read a lot on the topic and wanted to share his findings.