The Allow The Snow To Melt Method
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This article is about whether a debt avalanche or a debt snowball is the most efficient way to get out of debt. So… first, for those who don’t know, let me explain what Debt Snowballing and Debt Avalanching really mean.
Debt Snowballing is when you pay off your debts from smallest balance to the largest balance. So for example, if you had an extra $100 per month, rather than pay $20 extra on five different debts, you would put all $100 on the smallest debt and then once it is paid off, roll it over onto the next smallest debt, until you pay everything off and become debt free.
Doing a Debt Avalanche is very similar, except instead of putting the $100 on the smallest debt, you would put it on the debt with the highest interest rate and once it is paid off, roll it over onto the second highest interest rate etc, etc.
While both of these methods work much better than haphazardly paying off your debts, the million dollar question is… which one works best?
Well…. let’s find out! Let’s do an illustration.
Let us say that you are fresh out of college, so you decide to go out and buy a new house and car to go with the debt that you probably have already accumulated. Now that you are in deep debt, it is time to make your game plan to get out of this debt and plan for retirement. Here are your current debts.
Mortgage = $165,000. Interest rate = 7%. Monthly Payment = $1,097.75
Car = $15,000. Interest rate = 12%, Monthly Payment = $498.21
Credit Card #1 = $10,000. Interest rate = 11%. Monthly Payment = $200.00
Credit Card #2 = $5,000. Interest rate = 17%. Monthly Payment = $100.00
Credit Card #3 = $2,000. Interest rate = 10%. Monthly Payment = $50.00
Now, in this illustration we will say that you are able to come up with an extra $200 per month to work towards paying off your debt and going into retirement. This gives you a total of $2,145.96 to work with per month, and after you get done paying off your debt, you will then put your money into an investment vehicle that pays 9%. This illustration will start in September of 2009.
If you didn’t do anything at all and just paid the minimum on all of these debts, which is what a lot of people do, it would actually take you 354 months to pay off the debt. So… your debt would be paid off in February of 2039. That is almost 30 years (if there is NO re-borrowing or charging, which is unlikely), and at that point most people start to think about planning for retirement. So we will use the 360 months (30 years) for this illustration.
#1. First, let’s check out the Debt Snowball method.
Using the Debt Snowball method, you will pay off the debts from tiniest balance (CC #3) to biggest balance (Mortgage) by first putting the extra $200 on the smallest debt and rolling it up to the top.
If you do it this way, you will be out of debt in 134 months, in October of 2020, with your last payment being $235.31. That will leave $1,910.65 in the 134th month. So let’s take it a step further and say you put that into an investment vehicle paying 9% for the remaining 226 months. If you invest the $2,145.96 for the remaining time, then after 30 years you will have $1,272,825.48.
WOW! That is a huge difference. Buy using this method, you will be out of debt over 18 years sooner, AND you will have accumulated over a million dollars at about the same time that you would have just been paying off your debt by paying the minimum payments! But does that make it the best method to use? Let us continue.
#2. Now let us check out the Debt Avalanche method.
Using the Debt Avalanche method, you will pay off the debts from littlest interest (Mortgage) to largest interest (CC #3), which is the smallest debt) by first putting the extra $200 on the highest interest and rolling it over to the debt with the lowest interest.
If you do it this way, you will then be out of debt in 133 months, in September of 2020, with your last payment being $1,976.95. That will leave $169.01 in the 133rd month. So let’s say you put that into an investment that pays 9% for the remaining 227 months. If you invest the $2,145.96 for the remaining time, then after 30 years you will have $1,275,020.64. That is one month earlier of being debt free, and approximately $2,000 in extra cash at the end, using the Debt Avalanche.
Now in this particular instance, the Debt Avalanche won, but not by much at all. Generally speaking, Debt Avalanche will always win. but it certainly won’t be by a huge margin. You see, mathematically speaking, the quickest way to pay off your debt is from the highest interest to the lowest. But, if this is really the case, then why do so many people subscribe to Debt Snowballing? There are those that say that Debt Snowballing provides quick victories. If you pay your smallest debt off quickly, it will make you feel good and give you more incentive to move on. I can completely understand this, especially considering that there is not a big difference between doing the two.
Now, I am not one to do a financial plan based on how disciplined I think most people are. That is a slippery slope that many financial advisors choose to go down. That way they can (for example) sell someone a jacked up whole life insurance policy and justify it by saying, “Yeah I know, there is a more economical way, but my client is not disciplined enough to follow through on it”. In most cases, I just analyze and give the numbers.
#3. There is a method that has not been explored yet, and if you are reading this newsletter, you should feel lucky because you are one of the first to be exposed to this brand new revolutionary way to pay off your debt. It’s called the “Let The Snow Melt” method.
You can go here to finish the rest of this article on the best way to get out of debt.
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To Our Success,
Mark
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