This is a collaborative post
Getting out of debt needs to be a priority if you want to achieve true financial security. There are many ways to accomplish this. One of the more popular techniques is the debt snowball method, where debtors prioritize their debt accounts in order, starting with the smallest balance first, then moving down the list in order from smallest to largest.
The idea is to put as much money as possible toward your smallest debt while making the minimum on every other balance. Once you pay that off, you move the funds you would’ve put toward that debt to the next smallest balance and continue the cycle until you’ve completely paid off your debt.
The debt snowball allows consumers to experience a sense of accomplishment each time that they pay off a balance. Because small balances take less time to pay, those wins come quickly in the early stages of the plan.
That’s a great way to build momentum, but the technique itself could end up costing you more in the long run than other methods you could try.
Balances continue to increase on high-interest debt
This point is moot if the smallest accounts also have the highest interest rates, but that’s not always the case. If your smallest account has a 5% interest rate and your largest balance is at 25%, you’re still accruing interest at a rapid clip while you’re working through the plan. You’ll be taking on long-term losses while you’re experiencing those short-term wins.
In a debt snowball plan, for the scenario below, you’d begin with paying the personal loan, which is the smallest balance. It also has the lowest interest rate, so the credit card and store card will continue to accumulate high interest.
- Personal Loan: $2,000, 5% APR, Minimum Monthly Payment: $80
- Credit Card: $3,000 balance, 15% APR, Minimum Monthly Payment: $120
- Store Card: $5,000 balance, 25% APR, Minimum Monthly Payment: $200
Using the debt snowball method and adding an additional $100 per month to the target account, the total interest you’d pay on these balances would be $2,294 by the time they’re paid off, which in this scenario would be 25 months. Keep in mind that this is a small sample size. According to Experian, the average consumer debt in the U.S. for 2020 was $92,727.
Comparing debt snowball to debt avalanche
Another technique, the debt avalanche method, prioritizes the highest interest rate first. The payoff concept is the same: Make your minimum monthly payments on all accounts and add an extra payment to the target account.
With debt avalanche, the order of the payoff priority list above would change to the following:
- Store Card: $5,000 balance, 25% APR, Minimum Monthly Payment: $200
- Credit Card: $3,000 balance, 15% APR, Minimum Monthly Payment: $120
- Personal Loan: $2,000, 5% APR, Minimum Monthly Payment: $80
The total principal debt of $10,000 is still the same, but you’ll be targeting the store card with a 25% interest rate as your first account to pay off.
Using the same system as above, adding an extra $100 to target account payments, you’re looking at 24 months and only $1,894 in total interest payments. That’s a savings of $400 and you’ll be done a month sooner.
Multiply all these numbers by nine to reach the national debt average. At $90,000, the savings number balloons up to $3,600. Based on that, the debt avalanche appears to be the superior debt payoff strategy in this scenario.
You won’t experience the same frequency of small early wins that you get with debt snowball, but you can celebrate at the end with more money in your pocket.
Kevin Flynn
Kevin is a former fintech coach and financial services professional. When not on the golf course, he can be found traveling with his wife or spending time with their nine wonderful grandchildren and two cats.
Sources:
https://www.nasdaq.com/articles/this-popular-get-out-of-debt-strategy-could-cost-you-%241411-2021-09-04
https://www.experian.com/blogs/ask-experian/research/consumer-debt-study/
https://www.credello.com/debt/debt-snowball-calculator/
Last Updated on 1st September 2022 by Emma
