Reducing your debts: Avalanche method v snowball

0

Do you have debts? It turns out that a many Australians are also burdened with loans. Besides, we don’t really want to talk about it.

A quarter of Australians ignore their debt because they don’t want to discuss itwhich leads to feelings of anxiety and embarrassment, according to a study by ING.

An ING spokesman, David Breen, said “the problem with not talking about debt is that the options to solve the problem don’t come easily.”

But now you’re ready to take control of your finances. You have decided to start paying off your debt. Awesome!

However, achieving a debt-free life is easier said than done. You’re not sure which method to use to settle your many debts, which can be an overwhelming mix of credit card debt, personal loansstudent loans, car loans and payday loans.

To help you get started, today we will discuss the debt avalanche method and the debt snowball method.

These debt avalanche and debt snowball methods are nearly identical in that they both require you to list all of your consumer debts and pay minimum payments on all but one. The goal is to first clear the debt that you are paying above the minimum. The methods only differ on the debt you target first.

Let’s find out the difference between the two methods to help you decide which is best for you.

Both methods start by listing your debts, but differ in what they prioritize.

With the debt avalanche method, also called debt stacking, you arrange your debts by interest rate from highest to lowest, regardless of the balance. This involves making minimum payments on all of your current accounts, then using the remaining money to pay off the loan with the highest interest rate.

If the debt with the highest interest rate is paid off, then you apply the same strategy to the one with the second highest interest rate, until it is fully paid off.

The method is called avalanche because it aims to build momentum, similar to an avalanche that starts small and builds up more speed and power as it goes.

Advantages and disadvantages of the debt avalanche method

The main advantage of the debt avalanche method is that it saves you hundreds of dollars in interest payments.

For people with larger debts, this method can also significantly reduce the time it takes to pay off debt by a few months. If you’re able to make substantial payments while still having enough money for your day-to-day expenses, this can be a good way to help you get out of debt faster.

Sounds foolproof, right? However, it also has its drawbacks. It takes strict discipline to put all of your extra allotted into the payment of a particular loan, not just the minimum payment. Skipping just a month or two of strategic repayments can derail this strategy and it won’t work as effectively.

This approach also assumes that you have a specific, constant amount of discretionary income that you can use to pay off your debts. This means that an increase in your living expenses (rent, groceries, utilities, etc.) or emergencies could throw a wrench in the strategy.

With the debt snowball method, the focus is on the amount of your debt, not the interest rate. In simple terms, you pay off your debt from the smallest balance to the largest balance.

Make a list of all outstanding amounts you owe, in ascending order of amount. The interest rate is not taken into account. The idea is to first pay off the smaller debts to eliminate them before moving on to the larger ones – the epitome of the “tackle the easy stuff first” approach. You can think of it as a snowball rolling down a hill and picking up more speed and size as you go.

The smaller loan will be your first target, putting as much extra money into each payment as you choose.

Just like the avalanche method, you will only pay the minimum payment for other loans. When the first smaller loan is settled, you can switch to the second smaller one for processing additional payments. Repeat this process until you have exhausted all your debts.

Advantages and disadvantages of the debt snowball method

The main benefit of the debt snowball is that it helps build motivation.

Paying back what you owe is not an exciting prospect. Especially if you have lots of small debts to settle; keeping track of multiple minimum payments can be overwhelming. And it’s even harder if you can’t seem to reduce your debt. Without a sense of progress, it is very easy to become demotivated and derailed.

Personal finance author and talk show host Dave Ramsey, a strong proponent of the snowball method, points to our need for instant gratification that makes the snowball method so effective.

“The calculations seem to lean more towards paying the highest debts first,” he said. “But what I learned is that personal finance is 20% knowledge and 80% behavior. You need quick wins to stay motivated enough to get out of debt completely.

When you pay off your debts from the smallest to the largest balance, you can start freeing yourself of those small debts at a rapid pace. It gives you a sense of progress, as well as gratification. You are motivated by improving your financial situation.

In the long run, it will be easier for you to tackle larger debts such as your car loan or large credit card balances because you have the confidence as well as the extra cash to clear all your debts.

Eliminating multiple outstanding balances in just a few months helps you stick to the plan and makes the mountain of debt you’re facing look like it can be conquered.

Moreover, it is easier to implement. You don’t need to compare interest rates and annual percentage rate (APR), just focus on the amount.

The big downside of the debt snowball is that it can be more costly overall. Because you’re focusing on balances versus APRs on your loans, you might end up paying more interest. Compared to the avalanche method, reaching debt-free status may also take longer, depending on the nature of the debts and how often the interest rate on the loans is compounded.

So what is the best repayment method?

The snowball and avalanche methods are almost identical in that you will be able to pay off your debt quickly (depending on how much you owe).

Determining which is the best approach will depend on whether we are speaking in financial or psychological terms.

If you’re looking to save money, the math shows that the avalanche of debt is the most effective method. Because you pay debts based on their APR, you end up paying less interest. This means a less expensive debt payment, given that you stick to the payment plan.

But humans are often irrational (and sometimes emotional) when it comes to money. For some people, it can be much easier to stay motivated if they settle small debts first, regardless of the interest rate.

So while the snowball method may cost more, it’s psychologically better for them because they’re more likely to stick with the strategy. It also prevents them from abandoning the plan or, worse, falling back into debt.

Ultimately, both debt repayment strategies are helpful and can help you regain your financial freedom. Your financial situation as well as your personal preferences should also be taken into consideration when choosing the strategy that is best for you.

Which method do you think will work best for you? To learn more about how you can manage your loans, explore Nestegg today!

Reducing your debts: Avalanche method v snowball



Nestegg-logo


Last update: July 28, 2021

Posted: July 28, 2021

Share.

About Author

Comments are closed.