Snowball vs Avalanche - Paying off $100k+

Snowball vs Avalanche - Paying off $100k+

Let's start by defining both strategies and then discuss which one is best for you.

Snowball Method for Paying Off Your Loans

I hope everyone enjoys my amazing graphics. The Snowball approach only take into consideration debt size and nothing else. The strategy involves paying the minimum amount on all other debts except the smallest debt. The smallest debt will become your primary objective and any extra money you have will be thrown at the smallest debt. Once you've finished paying off the smallest debt you will then move on to attacking the next smallest until you pay off all your loans. This is not the most cost effective way to pay back your loans since the Avalanche method, as we will see, in the next section will actually end up costing you less. 

Knowing that the Avalanche method will cost you less money, why are we even discussing the Snowball method? The reason is because a lot of people believe that psychologically this is an approach that will give you quick small wins that will continue to encourage you to keep pay off your debt.  

Let's drive this point home with an example. Let's say that every month you had $1500 left over to distribute among your loans and you had a total of 5 loans of different sizes and interest rates.

As can be seen from the image above each loan has its own minimum payment which is part of the Snowball strategy. You should still be paying those minimum amounts (as depicted by the green boxes on top of each loan) on every loan. The money that remains should be thrown directly towards the loan with the smallest amount (our loans have conveniently been arranged from smallest to largest). This additional payment is the larger green box with the $1,251.55 currently being payed to Loan 4.

As you pay off Loan 4 you then would move all your remaining money to the next smallest loan.

Avalanche Method for Paying Off Your Loans

As was mentioned earlier this method will be the most cost effective and will also allow you to pay off your debts earlier. What it will not give you is that psychological incentive of having paid off a loan very quickly keeping you motivated. If you are the type of person that is less emotional and more calculative then this is really the way to go. If you are the type of person that performance better with instant gratification the snowball method may be best for you. 

For the Avalanche method let's show the same example but notice that the loans are now in different order. The loans are now arranged from highest interest rate to lowest, completely independent from the actual loan amount.   

Other than the order by which we will tackle these loans all the other rules still apply. We will continue to apply minimum payments and apply the rest of our money towards the smallest interest loan.

You can think of the interest rate as the cost of keeping a loan. The higher the interest rate the more expensive the loan will be. The Avalanche method is more cost effective because it gets rid of these loans the fastest. 

As I had mentioned in my +$100k of Student loans post when I graduated from college I have a little over $100k worth of student debt.  I remember writing code in python for me to simulate all the different ways I could attack my loans so that I would pay as little as possible. It turned out that by choosing the pay off my debt using the Avalanche method rather than the Snowball method would save me a few thousands of dollars, so I quickly started doing so. 

Unbury.me has a create calculator on its website that allows you to put your specific situation and it will tell you exactly how much money you would save by going with Avalanche instead of Snowball do check it out. 

It is fascinating to me how financial institutions or even universities don't teach students about these concepts essentially dooming the students to over pay.

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.