You are struggling with your loans and credit card debt. And you don’t have just one loan. You have quite a few. Your cashflows don’t permit you to attack all of them at once. At the same time, you don’t want to let your cashflows affect your credit score in a big way. To put it simply, you do not want to default on any of the payments. Therefore, you will make minimum payments on all your cards/loans and use the excess to close the targeted loan first.
Which should be your target loan to close first? The smallest one or the one with the highest cost of interest?
Debt Snowball and Debt Avalanche
- Under Debt Snowball method, you concentrate on closing the smallest loan first.
- Under the Debt Avalanche approach, you concentrate on closing the costliest loan first.
Let’s consider these 3 debts. These could be credit card debt, a personal loan or any other kind of loan. Though various loans have different repayment structures, let’s assume for now that you must make minimum payment of each of the loans to avoid credit score hit and any excess can be diverted to one of the loans.
- Debt 1: Rs 4 lacs at 20% p.a. Minimum monthly payment of 5% of the outstanding amount.
- Debt 2: Rs 6 lacs at 30% p.a. Minimum monthly payment of 5% of the outstanding amount.
- Debt 3: Rs 8 lacs at 40% p.a. Minimum monthly payment of 5% of the outstanding amount.
5% is usually the minimum amount due in credit cards. Every month, you will pay the minimum amounts for each loan. Let’s say you can pay Rs 90,000 per month. This is just the amount good enough to meet minimum payments for the first month.
Under Debt Snowball Method
We target the lowest loan amount first. Excess amount will go towards settling Rs 4 lacs. Once the Rs 4 lacs loan is finished, we target Rs 6 lacs. Once Rs 6 lacs loan is finished, the entire payment goes to the Rs 8 lacs loan.
i.e., Debt 1, Debt 2, Debt 3
Under Debt Avalanche Method
We target the highest cost loan first. Excess every month will go to reduce Rs 8 lacs loan (40%) amount. Once Rs 8 lacs loan is paid off, the excess goes to the Rs 6 lacs loan (30%). Therefore, all the resources are focused on to finish Rs 4 lac loan.
i.e., Debt 3, Debt 2, Debt 1
The Results
Under Debt Snowball method, it takes 30 months to close all the loans. The first loan (Rs 4 lacs, 20%) gets closed in the 16th month, the second loan (Rs 6 lacs, 30%) gets closed in the 24th month and the third loan (8 lacs,40%) gets closed in the 30th month.
Under Debt Avalanche method, it takes 29 months to close all the loans. The first loan (Rs 8 lacs, 40%) gets closed in the 23rd month, the second loan (Rs 6 lacs, 30%) gets closed in the 27th month and the third loan (4 lacs,20%) gets closed in the 29th month. Compared to debt snowball method, you pay Rs 1.03 lacs less.
Therefore, the debt avalanche method clearly looks a better choice.
| Debt Snowball Method | |||||||||||
| Loan 1 | Loan 2 | Loan 3 | |||||||||
| O/S at the beginning of the month | Monthly Payment | O/S at the end of month | O/S at the beginning of the month | Monthly Payment | O/S at the end of the month | Minimum Payment next month | O/S at the beginning of the month | Monthly Payment | O/S at the end of month | Minimum payment next month | |
| 1 | 4,00,000 | 20,000 | 3,86,667 | 6,00,000 | 30,000 | 5,85,000 | 29,250 | 8,00,000 | 40,000 | 7,86,667 | 39,333 |
| 2 | 3,86,667 | 21,417 | 3,71,694 | 5,85,000 | 29,250 | 5,70,375 | 28,519 | 7,86,667 | 39,333 | 7,73,556 | 38,678 |
| 3 | 3,71,694 | 22,803 | 3,55,086 | 5,70,375 | 28,519 | 5,56,116 | 27,806 | 7,73,556 | 38,678 | 7,60,663 | 38,033 |
| 4 | 3,55,086 | 24,161 | 3,36,843 | 5,56,116 | 27,806 | 5,42,213 | 27,111 | 7,60,663 | 38,033 | 7,47,985 | 37,399 |
| 5 | 3,36,843 | 25,490 | 3,16,967 | 5,42,213 | 27,111 | 5,28,657 | 26,433 | 7,47,985 | 37,399 | 7,35,519 | 36,776 |
| 6 | 3,16,967 | 26,791 | 2,95,458 | 5,28,657 | 26,433 | 5,15,441 | 25,772 | 7,35,519 | 36,776 | 7,23,260 | 36,163 |
| 7 | 2,95,458 | 28,065 | 2,72,318 | 5,15,441 | 25,772 | 5,02,555 | 25,128 | 7,23,260 | 36,163 | 7,11,206 | 35,560 |
| 8 | 2,72,318 | 29,312 | 2,47,544 | 5,02,555 | 25,128 | 4,89,991 | 24,500 | 7,11,206 | 35,560 | 6,99,352 | 34,968 |
| 9 | 2,47,544 | 30,533 | 2,21,137 | 4,89,991 | 24,500 | 4,77,741 | 23,887 | 6,99,352 | 34,968 | 6,87,697 | 34,385 |
| 10 | 2,21,137 | 31,728 | 1,93,095 | 4,77,741 | 23,887 | 4,65,798 | 23,290 | 6,87,697 | 34,385 | 6,76,235 | 33,812 |
| 11 | 1,93,095 | 32,898 | 1,63,415 | 4,65,798 | 23,290 | 4,54,153 | 22,708 | 6,76,235 | 33,812 | 6,64,964 | 33,248 |
| 12 | 1,63,415 | 34,044 | 1,32,094 | 4,54,153 | 22,708 | 4,42,799 | 22,140 | 6,64,964 | 33,248 | 6,53,882 | 32,694 |
| 13 | 1,32,094 | 35,166 | 99,130 | 4,42,799 | 22,140 | 4,31,729 | 21,586 | 6,53,882 | 32,694 | 6,42,984 | 32,149 |
| 14 | 99,130 | 36,264 | 64,518 | 4,31,729 | 21,586 | 4,20,936 | 21,047 | 6,42,984 | 32,149 | 6,32,267 | 31,613 |
| 15 | 64,518 | 37,340 | 28,253 | 4,20,936 | 21,047 | 4,10,412 | 20,521 | 6,32,267 | 31,613 | 6,21,729 | 31,086 |
| 16 | 28,253 | 28,724 | – | 4,10,412 | 30,190 | 3,90,483 | 19,524 | 6,21,729 | 31,086 | 6,11,367 | 30,568 |
| 17 | – | – | – | 3,90,483 | 59,432 | 3,40,814 | 17,041 | 6,11,367 | 30,568 | 6,01,178 | 30,059 |
| 18 | – | – | – | 3,40,814 | 59,941 | 2,89,393 | 14,470 | 6,01,178 | 30,059 | 5,91,158 | 29,558 |
| 19 | – | – | – | 2,89,393 | 60,442 | 2,36,186 | 11,809 | 5,91,158 | 29,558 | 5,81,306 | 29,065 |
| 20 | – | – | – | 2,36,186 | 60,935 | 1,81,155 | 9,058 | 5,81,306 | 29,065 | 5,71,617 | 28,581 |
| 21 | – | – | – | 1,81,155 | 61,419 | 1,24,265 | 6,213 | 5,71,617 | 28,581 | 5,62,090 | 28,105 |
| 22 | – | – | – | 1,24,265 | 61,895 | 65,476 | 3,274 | 5,62,090 | 28,105 | 5,52,722 | 27,636 |
| 23 | – | – | – | 65,476 | 62,364 | 4,749 | 237 | 5,52,722 | 27,636 | 5,43,510 | 27,175 |
| 24 | – | – | – | 4,749 | 4,868 | – | – | 5,43,510 | 85,132 | 4,76,495 | 23,825 |
| 25 | – | – | – | – | – | – | – | 4,76,495 | 90,000 | 4,02,378 | 20,119 |
| 26 | – | – | – | – | – | – | – | 4,02,378 | 90,000 | 3,25,791 | 16,290 |
| 27 | – | – | – | – | – | – | – | 3,25,791 | 90,000 | 2,46,651 | 12,333 |
| 28 | – | – | – | – | – | – | – | 2,46,651 | 90,000 | 1,64,872 | 8,244 |
| 29 | – | – | – | – | – | – | – | 1,64,872 | 90,000 | 80,368 | 4,018 |
| 30 | – | – | – | – | – | – | – | 80,368 | 83,047 | – | – |
| Debt Avalanche Method | |||||||||||
| Loan 1 | Loan 2 | Loan 3 | |||||||||
| O/S at the beginning of the month | Monthly Payment | O/S at the end of month | O/S at the beginning of the month | Monthly Payment | O/S at the end of the month | Minimum Payment next month | O/S at the beginning of the month | Monthly Payment | O/S at the end of month | Minimum payment next month | |
| 1 | 8,00,000 | 40,000 | 7,86,667 | 6,00,000 | 30,000 | 5,85,000 | 29,250 | 4,00,000 | 20,000 | 3,86,667 | 19,333 |
| 2 | 7,86,667 | 41,417 | 7,71,472 | 5,85,000 | 29,250 | 5,70,375 | 28,519 | 3,86,667 | 19,333 | 3,73,778 | 18,689 |
| 3 | 7,71,472 | 42,792 | 7,54,396 | 5,70,375 | 28,519 | 5,56,116 | 27,806 | 3,73,778 | 18,689 | 3,61,319 | 18,066 |
| 4 | 7,54,396 | 44,128 | 7,35,414 | 5,56,116 | 27,806 | 5,42,213 | 27,111 | 3,61,319 | 18,066 | 3,49,275 | 17,464 |
| 5 | 7,35,414 | 45,426 | 7,14,502 | 5,42,213 | 27,111 | 5,28,657 | 26,433 | 3,49,275 | 17,464 | 3,37,632 | 16,882 |
| 6 | 7,14,502 | 46,686 | 6,91,633 | 5,28,657 | 26,433 | 5,15,441 | 25,772 | 3,37,632 | 16,882 | 3,26,378 | 16,319 |
| 7 | 6,91,633 | 47,909 | 6,66,779 | 5,15,441 | 25,772 | 5,02,555 | 25,128 | 3,26,378 | 16,319 | 3,15,498 | 15,775 |
| 8 | 6,66,779 | 49,097 | 6,39,907 | 5,02,555 | 25,128 | 4,89,991 | 24,500 | 3,15,498 | 15,775 | 3,04,982 | 15,249 |
| 9 | 6,39,907 | 50,251 | 6,10,986 | 4,89,991 | 24,500 | 4,77,741 | 23,887 | 3,04,982 | 15,249 | 2,94,816 | 14,741 |
| 10 | 6,10,986 | 51,372 | 5,79,980 | 4,77,741 | 23,887 | 4,65,798 | 23,290 | 2,94,816 | 14,741 | 2,84,989 | 14,249 |
| 11 | 5,79,980 | 52,461 | 5,46,852 | 4,65,798 | 23,290 | 4,54,153 | 22,708 | 2,84,989 | 14,249 | 2,75,489 | 13,774 |
| 12 | 5,46,852 | 53,518 | 5,11,563 | 4,54,153 | 22,708 | 4,42,799 | 22,140 | 2,75,489 | 13,774 | 2,66,306 | 13,315 |
| 13 | 5,11,563 | 54,545 | 4,74,070 | 4,42,799 | 22,140 | 4,31,729 | 21,586 | 2,66,306 | 13,315 | 2,57,429 | 12,871 |
| 14 | 4,74,070 | 55,542 | 4,34,330 | 4,31,729 | 21,586 | 4,20,936 | 21,047 | 2,57,429 | 12,871 | 2,48,848 | 12,442 |
| 15 | 4,34,330 | 56,511 | 3,92,297 | 4,20,936 | 21,047 | 4,10,412 | 20,521 | 2,48,848 | 12,442 | 2,40,553 | 12,028 |
| 16 | 3,92,297 | 57,452 | 3,47,922 | 4,10,412 | 20,521 | 4,00,152 | 20,008 | 2,40,553 | 12,028 | 2,32,535 | 11,627 |
| 17 | 3,47,922 | 58,366 | 3,01,154 | 4,00,152 | 20,008 | 3,90,148 | 19,507 | 2,32,535 | 11,627 | 2,24,784 | 11,239 |
| 18 | 3,01,154 | 59,253 | 2,51,939 | 3,90,148 | 19,507 | 3,80,395 | 19,020 | 2,24,784 | 11,239 | 2,17,291 | 10,865 |
| 19 | 2,51,939 | 60,116 | 2,00,221 | 3,80,395 | 19,020 | 3,70,885 | 18,544 | 2,17,291 | 10,865 | 2,10,048 | 10,502 |
| 20 | 2,00,221 | 60,953 | 1,45,942 | 3,70,885 | 18,544 | 3,61,613 | 18,081 | 2,10,048 | 10,502 | 2,03,046 | 10,152 |
| 21 | 1,45,942 | 61,767 | 89,039 | 3,61,613 | 18,081 | 3,52,572 | 17,629 | 2,03,046 | 10,152 | 1,96,278 | 9,814 |
| 22 | 89,039 | 62,557 | 29,450 | 3,52,572 | 17,629 | 3,43,758 | 17,188 | 1,96,278 | 9,814 | 1,89,735 | 9,487 |
| 23 | 29,450 | 30,431 | – | 3,43,758 | 50,082 | 3,02,270 | 15,114 | 1,89,735 | 9,487 | 1,83,411 | 9,171 |
| 24 | – | – | – | 3,02,270 | 80,829 | 2,28,997 | 11,450 | 1,83,411 | 9,171 | 1,77,297 | 8,865 |
| 25 | – | – | – | 2,28,997 | 81,135 | 1,53,587 | 7,679 | 1,77,297 | 8,865 | 1,71,387 | 8,569 |
| 26 | – | – | – | 1,53,587 | 81,431 | 75,996 | 3,800 | 1,71,387 | 8,569 | 1,65,674 | 8,284 |
| 27 | – | – | – | 75,996 | 77,896 | – | – | 1,65,674 | 12,104 | 1,56,332 | 7,817 |
| 28 | – | – | – | – | – | – | – | 1,56,332 | 90,000 | 68,937 | 3,447 |
| 29 | – | – | – | – | – | – | – | 68,937 | 70,086 | – | – |
| 30 | – | – | – | – | – | – | – | – | – | – | – |
What Should You Do?
Even before crunching all these numbers, you expected the Debt Avalanche method to deliver better results in an excel sheet. Didn’t you? By paying the high cost loan first, you are reducing the future interest liability and therefore your total payments. However, choosing the repayment strategy is much more than a financial decision. You must be able to stick to the strategy and not get disheartened and quit after a few months feeling disappointed.
It may be easier to stick to a strategy if you can sense the progress. Therefore, the path you take may be rooted in your psychology. Harvard Business Review quoted a study that ruled heavily in favour of concentrating on small loans first (Debt Snowball). According to the article, “focusing on paying down the account with the smallest balance tends to have the most powerful effect on people’s sense of progress – and therefore their motivation to continue paying down their debts.”
Let’s go back to the example we discussed.
- Under the debt snowball method, we would have closed the first loan in 16th month, the second in the 24th and the third in the 30th month.
- Under debt avalanche, we would have closed the first loan in the 23rd month, the second in 27th and the third in 29th.
If the findings of the HBR article are relied upon, many borrowers may prefer the debt snowball method because the number of loans goes down faster (and not necessarily the amount). Psychologically, it is comforting to have 2 loans instead of 3. More importantly, it is easier to relate the progress of your efforts.
What would you do?
Points to Note
- I have not considered the impact of GST on credit card payments. GST is charged at 18% on the interest portion of the statement. By the way, that is likely to tilt the scale even more in favour of higher interest loans (debt avalanche). Only in the spreadsheet though.
- There may be some ancillary charges such as late payment etc. I have not considered the impact of such charges either.
- This concept of minimum payment due does not really apply to EMI based loans. However, the banks may let you just pay the interest amount just to avoid the loan becoming an NPA in their books. I have brought in loans to provide contrasting interest rate.
- Even if we are to include a loan as an example, some of the loans may have prepayment penalty that can make the equation even more complex. There are no restrictions on credit card payments. However, I have not assumed such complexity in the analysis.
- The spread of interest rate on these loans is quite high. If the rates are same or very close, then there is little difference between the two methods. In fact, in such cases, debt snowball will be a very fair choice.
Credit: Debt Snowball Vs. Debt Avalanche