DEBT SNOWBALL VS DEBT AVALANCHE | WHICH IS THE BEST DEBT PAYOFF STRATEGY?

Hey everyone Daniel here from Next Level Life and today I realized that I've been ignoring another big area of personal finance debt and I don't know how I can be a self-respecting personal financial YouTuber if I don't at least touch on that subject. So today I'm going to be talking about debt more specifically I'm going to be talking about two very popular ways that people try to pay off their debt and that is the debt snowball strategy and the debt avalanche strategy. I'm going to be talking about how both strategies work as well as the benefits and downsides to each. And then I'm going to wrap it all up by comparing the two in a very similar example to see which one actually works better. First I'm going to be talking about the debt snowball. How does it work? Well the debt snowball as made famous by Dave Ramsey tells you that you should be paying off the debt with the lowest balance first regardless of what the interest rates on all your debts are. balance and you pay them off in that order. Making minimum payments on all of them except for the smallest one and attacking that smallest one with a vengeance. Throwing everything you've got at it selling so many things that the kids think they're next and you do that until you've paid off that smallest debt and once you've paid off that smallest debt you take the minimum payment that you were using towards that smallest debt as well as all the extra money you were throwing at it and you move it to the new smallest debt. And when I get to the example I'll put some numbers to it so it makes a little more sense. But that's basically the concept. The benefits of course have been found to be very psychological in nature. Because you're paying off the smallest balance first you see progress very quickly at least in comparison to other debt payment strategies. And as each month goes by and you pay off more and more of your debts you get less and less bills coming into the household and that motivates you even more to continue paying off debt. The momentum continues to build up until you're finally debt free. That's the theory anyway. But there has actually been some evidence to back it up. In fact, the Harvard Business Review did do a study recently and found that people using the debt snowball did tend to actually finish paying off their overall debt more often than people who use other strategies. But that's not to say that there aren't downsides to using this strategy as well. The main one that people throw at the debt snowball is that it's not the most mathematically efficient way to pay off debt. And that is absolutely true. Probably the most mathematically efficient way to pay off debt is by using the debt avalanche. So let's get into that. The debt avalanche is as one of my finance professors back in college would often say similar to the debt snowball only different. The debt avalanche says that instead of ordering your debts from smallest balance to largest balance you should instead order them from the highest interest rate to the lowest interest rate and pay them off in that order. The benefits of course is that you do get out of debt faster than say with the debt snowball strategy because you're paying the higher interest rate debts off first which means you'll end up paying less interest overall in the long run. The downsides to the debt avalanche in my opinion are that it doesn't really take emotions into account and as I said just a moment ago studies like the Harvard Business Review have found that the debt snowball does tend to lead to people paying off more of their overall debt in the long run. So let's go through a quick example here to show how these two strategies work. Let's take John and Jane. John is going to use the debt snowball to pay off his debts and Jane is going to use the debt avalanche. For the sake of simplicity I'm going to assume that they both make the same amount of income and they both have the same amount of taxes, the same amount of expenses, all that jazz. Same amount of debts. And again just to keep things simple I'm going to leave it to three debts. I'm going to have them have a $25,000 credit card balance, $20,000 in student loans, and a $10,000 car loan. The interest rates for both John and Jane are going to be 15% on the credit card, 4.45% on the student loans, and 4.21% on the car loan. I chose these numbers mainly because they seem to be right around average. So the minimum monthly payments on the three debts will be $750 a month to the credit card, $200 a month to the student loan, and $185 to the car loan. The income for both John and Jane is going to be $59,000. They're both going to have expenses of $24,000 and as for taxes they're going to take the $24,000 standard deduction and pay about $8,750 a year to the government. Which means that both after taxes and expenses are going to start with about $1,052 left over at the end of every month after making their minimum payments on their debts. And I did the numbers this way because it leaves the credit card balance as the biggest balance and the highest interest rate. So we're going to see as big a difference as we can between the debt snowball and debt avalanche. So we'll start with John. As I said John will be using the debt snowball to pay off his debts. Since he's using the debt snowball he's going to start by trying to throw everything he's got at the car loan which is $10,000 in his case. He'll make the $185 minimum payment on the car loan as well as the $200 and $750 payments on the student loans and credit cards and throw all of that $1,052 that he has left over at the end of the month onto the car loan. In doing this he will have the car loan paid off in full in 9 months. Now his snowball payment will increase because he's no longer having to pay $185 a month on a car loan. Which means his new snowball payment is $1,237 a month now that he's going to be starting in month 10 paying off the student loans since that's the next lowest balance. And again for the sake of simplicity I'm just going to assume that the balance is still $20,000 for the student loan. So starting from month 10 of his debt payment strategy he will start knocking out that student loan as fast as he can and running the numbers we find that at the end of the 23rd month of his overall debt payment plan he has knocked out the student loans completely. Now all he has left is that credit card bill which again for the sake of simplicity I'm going to assume is still $25,000. John's snowball payment again increases because he's no longer having to put $200 a month to make the minimum payments on his student loans. Which means his snowball payment goes from $1,237 a month to $1,437 a month. He makes the minimum payment on his credit card and throws all of that snowball payment at it as well and pays off the credit card in full at the end of the 35th month. So in about 3 years John managed to pay off a $10,000 car loan, a $20,000 student loan, and a $25,000 credit card bill. But how does that compare to Jane? Jane is using the debt avalanche as I said she has the same debt, same income, same expenses. Except she's paying off the debts in a different order. Using the debt avalanche she pays off the debt with the highest interest rate first regardless of balance. Meaning that she's going to throw everything at the credit card bill right from the start. And what we see is Jane takes quite a long time to get that credit card bill paid off which is understandable it has a very high interest rate and it was the largest debt to begin with. But whereas John managed to pay off his first debt and see some progress at the end of 9 months Jane doesn't see any progress until the end of the 16th month almost twice as long as John. However, on the bright side she does have the credit card bill paid off in full so the biggest hurdle has been done and her snowball payment which again started at $1,052 has now increased to over $1,800 because she no longer has to make the $750 credit card bill minimum payment and she can throw all of that at her student loan which is the next highest interest rate at 4.45%. She'll do that starting in month 17 of her debt repayment plan and she'll have it paid off in full by the end of the 26th month. Now all she has left is the car loan and she can again just like John take that $200 that she no longer has to pay for her student loans and lump it into her avalanche payment which is now over $2,000 a month. So as you can imagine she pays off that $10,000 loan pretty darn quickly in fact by the end of the 30th month she is debt free. So she managed to pay off the same amount of debt as John in 5 fewer months. And the big reason for that of course is the difference in interest payments that these two made. John, using the debt snowball, kind of left his credit card bill until the end. It was the highest balance, it was the highest interest rate, he accumulated a lot of interest payments. In fact, he paid over $10,000 in interest over those 35 months. Meanwhile, Jane in her 30 months of debt repayment only paid about $4,700 in interest because she knocked out that credit card right away. So looking at the two and comparing them there's not really any question as to which one is going to get you out of debt faster. The debt avalanche will get you out of debt faster if you stick to it. The big reason why the debt snowball is so popular though is because it's very hard to stick to the debt avalanche when you're not really seeing any tangible progress for so long. Remember Jane did not have her first debt paid off until 16 months into her debt repayment strategy. That is a long time to not see much progress even if you know it's going to a good cause. So which debt repayment strategy is right for you really comes down to just knowing yourself and how you would handle these sort of situations. Which is going to motivate you more knowing that you're going to get out of debt faster even when you're not seeing any tangible progress right away or seeing the tangible progress seeing less and less bills coming in the mail every month even if it means you're going to pay a little bit more interest in the long run. So what did you think about these two debt payoff strategies? Have you heard of them? Did you learn something? Do you have another debt payoff strategy that you're using? Let me know in the comments section below and don't forget to like share and subscribe. I've got a lot more of these finance videos coming I will be uploading every single Friday at 4 p.m. Eastern Standard Time. So with that being said thanks for watching and have a great day!