Debt is like an anchor around your finances. This is triple-y true when you have high interest debt consuming much of your cashflow and income. There are 2 primary methods to pay down your debt, the snowball method and avalanche method.
The U.S consumer debt just reached over $16 Trillion and it is clearly an issue for many households. Learn about the 2 debt payoff methods and some alternative ways to help payoff your debt.
What Is Snowball Method of Debt Payoff?
The snowball method of debt payoff was made popular by Dave Ramsey. Under the snowball method you pay off the lowest balance debt first while making the minimum payments on all other debt.
You do this even if your lowest balance debt has the lowest APR.
Once that first loan is paid off, you put those payments into your next lowest balance debt. You continue doing this until you finally pay off the highest balance debt.
The thought behind this method is that you get positive feedback sooner from paying off a loan. As described by Ramsey, “the psychological boost you get from paying off a loan fully will help you stay on track of paying off debts”.
However, the downside is that you will incur more interest over the period due to leaving potentially higher APR loans outstanding.
Snowball Method of Debt Repayment – Example
To help understand how the snowball method works, here is an example:
- Student loan: $8,000 balance and 3.5% interest with $350 minimum payments
- Car loan: $7,000 balance and 3.0% interest with $215 minimum payments
- Credit Card Debt: $10,000 balance and 17% interest with $150 minimum payments
- Total Debt: $25,000 balance and 8.75% interest with $715 minimum payments
- You have $1,000 a month to spend on paying off your debts and a $715 minimum payment each month leading to $285 of excess initially
Under the snowball method, you pay off the lowest balance loan first. This would be the car loan, despite it having the lowest interest rate.
You would pay $500 to the car loan first ($500 = $215 minimum payment + $285 initial excess). It would take around 16 months to fully pay off the car loan.
When the car loan is paid off, you pay $850 to the student loan. ($850 = $350 minimum payment + $500 payment that was going to the car loan). Finally the full $1,000 payment goes to the credit card.
It takes 29 months to pay-off all $25,000 of debt using the snowball method in this example. And your total interest paid is ~$3,775.
What is the Avalanche Method of Debt Payoff?
Under the avalanche method of debt payoff, you put any excess payment into your highest APR loan and make the minimum payment on other balances.
By focusing on the higher interest debt first, you will pay less interest over the lifetime of the loans. This is the mathematically more efficient method of paying off debt.
In contrast to the snowball method, you won’t get the dopamine rush of seeing a balance go away as quick. However, if you have self-control, this will allow you to extinguish all our debts sooner.
The avalanche method is our preferred method as it can save you $1,000s in interest payments.
Avalanche Method of Debt Repayment – Example
Taking the same example as in the snowball method above (shown again for convenience):
- Student loan: $8,000 balance and 3.5% interest with $350 minimum payments
- Car loan: $7,000 balance and 3.0% interest with $215 minimum payments
- Credit Card Debt: $10,000 balance and 17% interest with $150 minimum payments
- Total Debt: $25,000 balance and 8.75% interest with $715 minimum payments
- You have $1,000 a month to spend on paying off your debts and a $715 minimum payment each month leading to $285 of excess initially
Under the Avalanche method, you would allocate $435 a month paying down your credit card debt as it is the highest APR at 17%. ($435 = $150 minimum payment + $285 excess). You do this despite the credit card having the highest balance.
Once the credit card debt is paid you add the $435 to the next highest interest debt, student loan. Therefore, you start paying $785 to the student loan. ($785 = $350 minimum payment + $435 in spare money since credit card is paid off.) And finally you pay the full $1,000 to the car loan every month till that is paid off.
In this example, it takes 28 months to pay off all the debt. You pay a total of ~$27,750 on the $25,000 debt. Your total interest is ~$2,750.
[Professor B.T. Effer Note – It would actually take ~28 months to pay off the car and student loan making the minimum payments. This means you would need to wait 28 months before any loan is fully paid off, but that last month all your debt is paid off.]
Snowball vs Avalanche Debt Payoff Comparison
Since we used the same example above, we can easily compare the two methods.
In total, you will spend ~$27,750 paying off your $25,000 in debts using the avalanche method. And you will spend ~$28,775 paying it off under the snowball method. The total payment is only 4% more with the more efficient avalanche method. But if you look at only the interest paid, you save over $1,000 with the avalanche. This is almost 40% less total interest paid.
The reason for the large difference in interest is that you are attacking the balance on the higher 17% APR credit card. Each excess payment you make to your credit card balance, is money not incurring the high interest.
“The avalanche method is always the lowest cost method to pay off debt”
Professor B.T. Effer
When using the snowball method, you are only paying the minimum payment on the high-interest credit card allowing for a higher balance to accrue interest.
Another way to think of debt payment is you are ‘earning’ a return equal to the APR. A dollar paid to the credit card is a dollar that ‘earns’ a 17% return. Compared to a dollar spent on the lower-interest loans that ‘earn’ 3-3.5% return. That is a huge difference.
Avalanche is ALWAYS less expensive
All else being equal, using the avalanche method will always result in a lower cost to you. Nearly all loans accrue interest on a daily frequency. The lower you can drive a balance on a high interest loan, the less total interest you pay. This results in a less expensive total payoff.
If you are able to stick to a debt payment plan, and don’t need the validation that comes with seeing 1 less account, avalanche is the better option.
Alternatives
There are a few additional alternative ways to help pay down your debt. These 4 alternatives can be combined with the snowball and avalanche methods discussed. They are:
- Debt consolidation
- Balance Transfer
- Purchase-to-Transfer Method TM
- Making more frequent payments
We will discuss each briefly here.
1) Debt Consolidation
Debt consolidation is when you take out a new consolidated loan to pay off all your smaller loans. Depending on the type of debt you have, debt consolidation may lower the overall APR you are paying.
The big benefit of debt consolidation is simplifying your finances. Instead of many small loans you are paying, you have one large loan.
However, if the APR on the consolidation is higher than any of your outstanding debt, you may want to keep those lower-interest loans separate to keep the total interest you pay lower.
2) Balance Transfer
Credit card balance transfers are done to get a 0% APR on the debt. Many new credit cards come with promotional 0% APRs for 12 or 18 months. By transferring your balance that is earning 20%+ APRs to a new card, you can save on interest.
However, nearly all balance transfers incur a 3-6% upfront balance transfer fee. This can result in $100s of fees added to your outstanding loans.
Additionally, if you do a balance transfer you need to pay at least the minimum payment each month or you may get hit with penalties and all the unpaid interest at the high 20%+ rate.
Lastly, balance transfers do not count towards any promotional rewards or cash back. Cards will often have promotions like “spend $500 in the first 3 months and get $200 of bonus points”. In order to receive the points, you need to make purchases.
This last point is a huge issue which leads us to our preferred balance transfer method…
3) “Purchase-to-Transfer” Method TM Cheat Code
The purchase-to-transfer method TM is a loophole we have used and recommend. Instead of doing a balance transfer and incurring a fee, you instead use purchases to transfer the balance.
How this works is you open a new card with a promotional APR. Then you put every spending item on the new card. Since you aren’t using your cashflow for day-to-day purchases, you use your income to pay off the previous high-interest card.
Not only do you avoid the balance transfer fee, your purchases are all eligible for rewards and promotional bonuses. If you have $1,000 balance and do a traditional balance transfer you incur a ~$50. This assumes a 5% transfer fee.
Using the purchase-to-transfer method TM cheat code, you don’t get the $50 fee. And you also get a promotional bonus and rewards on the purchase. If you have a card with a $200 promotional bonus and 2% regular cash back. You would earn $200 and $20 on your purchases.
That is a net benefit to you of $270. ($270= $50 transfer fee you avoid + $200 promotional bonus + $20 regular cash back).
And the best part, as long as you can continue to open up new credit cards, you are able to continue using this method. When your 0% promotional period is coming to an end, you do another purchase-to-transfer to a new card. Each new cards gives new rewards and cash back while you roll your debts. It is truly a cheat code that can save $1,000s.
You can read all about our patented purchase-to-transfer method TM here.
4) More Frequent payments
Interest is typically charged daily on the balance. If you pay $250 twice a month instead of waiting and paying $500 at the end of the month, you will save yourself significant interest.
Nearly all loans allow prepayments and many companies have even started offering bi-weekly payments as a service.
The Final Word
Debt isn’t fun. We have provided an overview of the avalanche and snowball methods of debt repayments. Additionally, we have provided 4 alternatives that can be used to further improve your debt pay off.
We personally would recommend using the purchase-to-transfer method TM with the avalanche method to attack your debt in the most efficient way possible.
But at the end of the day, the method that you will stick with is the best choice.
Frequently Asked Questions (FAQs):
The 2 main methods to payoff outstanding debt are the snowball and avalanche methods.
Under the snowball method, you ignore the APR and pay off the lowest balance loans first. You pay the minimum payment on all other debt until that loan is paid off. Once the first loan is paid off, you apply all the money that was going to that loan towards the new lowest balance loan.
The avalanche method targets the highest APR loan first and ignores the loan balances. After the highest APR loan is paid off, the money is applied to the next highest APR.
The snowball method of debt payoff is when you pay your lowest balance debt first regardless of the APR. You pay the minimum payments on all other debt. Once that debt is eliminated you put those payments towards the next lowest balance.
The pros of the snowball method are psychological. You get positive feedback by seeing one of your accounts go away.
The cons of the snowball method are you pay higher interest due to keeping higher APR debt.
The avalanche method of debt payoff is when you pay the highest APR debt off first. You pay the minimum payments on all other debt. After the highest APR debt is paid off, you put those payments towards the next highest APR loan.
The pros of the avalanche method is you pay the least amount of interest and eliminate all your debt faster. It is the mathematically best approach.
The cons of the avalanche method is that you don’t get the dopamine rush of seeing a debt go away fast like under the snowball method.
Debt consolidation is when you transfer numerous outstanding debts onto one new loan. This serves to simplify your debt situation by centralizing all your debts. This is especially worthwhile if you are able to refinance high-interest loans into a lower APR consolidated loan. Consolidating debt can save you in interest and complexity when done correctly.
However, if you have low interest debt, you may want to keep those separate. Additionally, by having one large loan, you will have a high minimum payment for a long period of time.
If you have a lot of outstanding credit card debt, one option is to open a new credit card and do a balance transfer. Many cards offer 12-18 month promotions where you incur 0% APR on new purchases and balance transfers. You just need to make the minimum payment or else you get charged back interest and fees.
However, balance transfers typically have a 3-6% upfront fee. This means you could pay $100s in fees for the transfer. A better method is the “purchase to transfer” method TM which allows you to transfer your balance through new purchases. This way you not only avoid the fees, but you gain promotional spending rewards and regular cash back points.
The purchase to transfer method TM allows you to transfer debt balances onto a new credit card without paying the 3-6% balance transfer fee. Nearly every credit card that has a 0% promotional APR applies it to both transfers and new purchases. Therefore, for a period of time after opening the card, you can make purchases and build a balance without incurring interest. You just need to pay the minimum payments.
Therefore, instead of doing a balance transfer for a fee, you put all your day-to-day purchases on the new card. Then you use the cashflow saved by charging all of life’s expenses towards paying off the balance on your other credit card. As long as your monthly spending is more than your outstanding card balance, you can transfer the balance effectively for free.
Additionally, you will gain any promotional rewards and regular cash back on purchases but don’t get this ‘free’ money on balance transfer amounts. Using the purchase-to-transfer method TM can save you $1,000s.