Intro
When it comes to paying off debt, the most important thing is to get your budget
in order to free up cash to actually make the payments. So if you're not there yet,
stop here and work on getting your budget in order.
In this post, I'll go through the two major debt repayment strategies with their
associated pros and cons, and at the end I'll discuss one potentially surprising
case where it's not so cut and dry which is better. In general, these strategies
attempt to optimize how quickly you pay off your debts.
How does interest work
In general, your interest rate is a yearly rate, but interest usually accrues
monthly (or daily for credit cards; more on that later).
So let's say your interest rate is 12%, this means your monthly rate is ~1%,
so every month you'd pay 1% of whatever money you owe in interest (so $10 for every $1000).
It's a little more complicated than that (i.e. APR vs APY), but that's close enough for our
purposes.
For this post, I'm going to be using the following for illustration purposes:
- credit card A: $1000 @ 24%
- credit card B: $500 @ 12%
- debt repayment of $200/month
- minimum repayment: 1% or $50, whichever is greater
So in the first month, here's how much interest we'll be paying:
- credit card A:
$1000 * (24%/12) = $20
- credit card B:
$500 * (12%/12) = $5
Since we have a minimum payment of $50 for each card, the rest will go toward
reducing the debt. So after the first month, if we only make minimum payments,
the debts will be:
- credit card A:
$1000 - $30 = $970
- credit card B:
$500 - 45 = $455
For the examples below, I'll be making extra payments with the payment, after interest accrues.
I'll also assume interest accrues as of the balance at the end of the month, not daily.
Grace period
The most common type of higher interest debt is credit card debt, and usually
these rates (in my area) are between 10-30%, usually >20%. Credit cards are a bit
special in that they usually (but not always!) have a grace period where you won't
pay any interest if you always pay your balance on time, but as soon as you fail to
pay your statement balance even once, you start accruing daily interest on all
balances (including new purchases) until the entire debt is repaid. So credit card
interest is especially insidious because whether you pay interest can change each
billing cycle.
This grace period can be violated in a number of ways, and each card may be a little
different there. In general, cash advances start accruing daily interest immediately,
balance transfers have a separate rate from normal purchases, and payments usually go
toward the highest interest portion first (so usually toward new purchase).
The grace period will be relevant later, but I'll be ignoring it for now.
Avalanche Method
In short: highest interest first.
Assuming your debt repayment stays constant, this is the mathematically optimal
repayment strategy and will save you the most interest.
One way of conceptualizing this is to find the average interest rate. We do this
by adding up all the debts, divide each debt by the total debt, multiply that by
the interest rate, and then sum that. That's a little complicated in text, so
here's a walk through of how that works:
$1000 + $500 = $1500 - $1500 total debt- for debt A:
$1000 / 1500 * 24% = 16%
- for debt B:
$500 / 1500 * 12% = 4%
- average debt:
16% + 0.04 = 20%
If you don't trust my math, here's an online calculator.
So on average, we're paying 20% interest on our debts. If I paid down half of debt A,
I'd instead be paying 18% average interest. If I paid down all of debt B, I'd be paying 24% average interest.
Let's walk through our example, every extra penny goes toward the highest interest debt.
- interest paid:
$1000*(24%/12) + 500*(12%/12) = $25; card A balance: $1000*(1 + 24%/12) - $150 = $870; card B balance = $500*(1 + 12%/12) - 50 = $455
- interest paid: $21.95, card A balance: $737.40; card B balance: $410.31
- interest paid: $18.85, card A balance: $602.15, card B balance: $365.10
Total payoff time: 7 months
Total interest: $110.70
Snowball Method
In short: lowest balance first.
The goal here is to eliminate as many debts/minimum payments as possible to reduce
the number of debt payments. This can be a huge psychological boost which can
encourage people to cut more from the budget to accelerate debt repayment.
Let's walk through our example:
- interest paid: $25, card A balance: $970.00, card B balance: $355.00
- interest paid: $22.95, card A balance: $939.40, card B balance: $208.55
- interest paid: $20.87, card A balance: $868.82, card B balance: $60.64qq`
Total payoff time: 7 months
Total interest: $113.85
Spreadsheet
Here is a spreadsheet I've made that details the simple case above,
as well as a more complicated case.
Both cases are intended for illustrative purposes only, I don't recommend using
this sheet for anything more than a high-level understanding of snowball vs avalanche
debt repayment strategies.
Corner case - unexpected expense
The second tab in that spreadsheet goes through a corner case where snowball
could actually be more advantageous. Here are the assumptions:
- one high interest, high balance card
- multiple lower interest, low balance cards
- unexpected expense higher than cash flow can handle happens 3 months after debt repayment starts
- cards have a grace period on new purchases
In this scenario, snowball is actually superior mathematically for a few months after
that unexpected expense happens, and then falls behind over the longer term.
The takeaway here is that if you have less predictable expenses, you may be better off
with the debt snowball method and/or having a larger emergency fund. The general advice
when doing debt repayment is to not make additional purchases on existing credit cards
so as to not add to the problem, but life happens.
Conclusion
If you'll look at both of my examples, the total interest paid isn't that different.
If you want to play with the numbers yourself with a better designed tool, check out
unbury.me and enter all of your debts, interest rates, and
minimum payments. I ran my above example through that website, and the total interest
paid is <$100 different between the two methods, and both would be finished around
the same time.
In general, debt avalanche is usually the optimal strategy, but use what works for you.
For me, debt avalanche is the way to go because I hate leaving money on the table more
than I like seeing monthly payments disappear, but the opposite is also completely sensible.
That said, the more debt you have, the higher the difference between avalanche and snowball,
so run the numbers before deciding.
If you'd like more posts like this, please let me know. I'd like to get more active in this community, but I don't know how technical people here would like me to get.