Expenses come in all shapes and sizes. Some are relatively small, like your monthly subscription to Netflix. Others are quite large and take up a large chunk of your budget each month, such as your mortgage payment. Your mortgage is just one type of debt that you might be paying on and at least your home’s value is increasing as you increase your equity. There are a few bad debts where this is not the case. College is more expensive now than it has ever been, and millions of Americans are paying off the debt of their degree for years after graduation. Maybe you decided to buy a new car off the lot and are paying it off over a number of years. On top of those debts, credit card payments are a major factor as many Americans also have racked up payables from overextending themselves through spending. Those three types of debts that I just mentioned can be very difficult to navigate. What debt do you pay off first? There are two main schools of thought in regard to this question. Let’s go over the two debt payment styles and what their advantages and disadvantages are.
The Snowball Method
For our Michigan readers, I know that snow is the last thing you want to think about since we are finally having some warmer weather. Don’t be alarmed, this method of debt payment does not have anything to do with actual physical snow and is simply a metaphor for how this style compounds on itself. The philosophy is that the debtor pays back, in their entirety, the smallest debts they have first. This is regardless of the interest rates that are attached to the debt. While minimum payments are made on all outstanding debt, any extra amounts available go towards paying off that smallest debt first. Let’s go through a quick example. Let’s say you own a car that you owe $7,000 at a 2.75% interest rate. You have student loan debt of $15,000 with an interest rate of 4% from your college days. In this scenario you also have credit card debts of $20,000 at an APY of 18.50%. The snowball method would say that you should tackle paying off the car first. The idea is that you can eliminate that smaller debt first before moving onto a larger, and the largest, debt amounts. The fulfilled payments start piling up and the paying off of some smaller debt is meant to give you the resolve going forward that you are capable of fulfilling your other debt obligations. Starting small rolls into something big. Just like the base of a snowman starts in the form of a snowball that fits in the palm of your hand. This method is aptly named.
The question here is, what about the fact you are leaving the credit card debt looming which has an extremely high interest rate? The snowball method prioritizes debt balances over against their interest rates, but that is the opposite case with the avalanche method.
The Avalanche Method
The avalanche method of paying off debt is a flip flop of the snowball method. The avalanche method is to rid yourself of the highest interest debt first regardless of the balance of the debt. You are, of course, still maintaining the minimum payments on all outstanding debt. If we use our last example, the credit card debt would be the first problem to be tackled. Despite the fact that you owe the most to the credit card company, that debt is being paid first so that you are not continuing to pay 18.50% interest. The avalanche method is meant to ensure that you are not paying interest unnecessarily while you pay off debts based on size like the snowball method suggests. The point is to minimize the total amount of interest paid. Rather than starting small and building up, you may end up starting large and descending down. Symbolically, an avalanche starts at the top of a mountain and breaks into pieces as it falls just like your total outstanding debt. Hence the name of the method.
The issue with following this is that it is difficult to have the discipline to follow this plan considering it may mean tackling your largest debt first. If the largest liability on your balance sheet is owed to a credit card company, it is likely you will be paying that off first as credit card debt is usually accompanied by very high interest rates. The commitment required to follow the avalanche is high level as it can be more difficult to see the light at the end of the tunnel. If you are a strict budgeter who is looking for the more cost-efficient option, this is the way to go.
So, which method should you go with? It should be the avalanche method considering the cost savings, right? It depends. I know that many of the questions in financial planning have that same answer, but it really is true. It is very possible that the avalanche method may be too daunting for someone looking to repay their debt. They may need to start small and work their way up to keep themselves disciplined. Others may be fully onboard with tackling the large if it means eliminating the debt they have with the highest interest rate. Our answer is all dependent on the person we are speaking with and who they are indebted to.
If you are looking to retire in the next few years and want to be debt free by the time you get there, we can help. If you want to set up a plan as a young person to get that debt paid off, but you don’t know where to start, reach out to us. We can help. I hope this blog gave you something to think about and makes you eager for next week’s topic. Thanks for reading and have a great Spring Break!