Overcoming Debt — Debt Snowball vs Debt Avalanche

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

  1. Under Debt Snowball method, you concentrate on closing the smallest loan first.
  2. 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 1Loan 2Loan 3
 O/S at the beginning of the monthMonthly PaymentO/S at the end of monthO/S at the beginning of the monthMonthly PaymentO/S at the end of  the monthMinimum Payment next monthO/S at the beginning of the monthMonthly PaymentO/S at the end of monthMinimum payment next month
14,00,00020,0003,86,6676,00,00030,0005,85,00029,2508,00,00040,000 7,86,667        39,333
23,86,66721,4173,71,6945,85,00029,2505,70,37528,5197,86,66739,333 7,73,556        38,678
33,71,69422,8033,55,0865,70,37528,5195,56,11627,8067,73,55638,678 7,60,663        38,033
43,55,08624,1613,36,8435,56,11627,8065,42,21327,1117,60,66338,033 7,47,985        37,399
53,36,84325,4903,16,9675,42,21327,1115,28,65726,4337,47,98537,399 7,35,519        36,776
63,16,96726,7912,95,4585,28,65726,4335,15,44125,7727,35,51936,776 7,23,260        36,163
72,95,45828,0652,72,3185,15,44125,7725,02,55525,1287,23,26036,163 7,11,206        35,560
82,72,31829,3122,47,5445,02,55525,1284,89,99124,5007,11,20635,560 6,99,352        34,968
92,47,54430,5332,21,1374,89,99124,5004,77,74123,8876,99,35234,968 6,87,697        34,385
102,21,13731,7281,93,0954,77,74123,8874,65,79823,2906,87,69734,385 6,76,235        33,812
111,93,09532,8981,63,4154,65,79823,2904,54,15322,7086,76,23533,812 6,64,964        33,248
121,63,41534,0441,32,0944,54,15322,7084,42,79922,1406,64,96433,248 6,53,882        32,694
131,32,09435,16699,1304,42,79922,1404,31,72921,5866,53,88232,694 6,42,984        32,149
1499,13036,26464,5184,31,72921,5864,20,93621,0476,42,98432,149 6,32,267        31,613
1564,51837,34028,2534,20,93621,0474,10,41220,5216,32,26731,613 6,21,729        31,086
1628,25328,7244,10,41230,1903,90,48319,5246,21,72931,086 6,11,367        30,568
173,90,48359,4323,40,81417,0416,11,36730,568 6,01,178        30,059
183,40,81459,9412,89,39314,4706,01,17830,059 5,91,158        29,558
192,89,39360,4422,36,18611,8095,91,15829,558 5,81,306        29,065
202,36,18660,9351,81,1559,0585,81,30629,065 5,71,617        28,581
211,81,15561,4191,24,2656,2135,71,61728,581 5,62,090        28,105
221,24,26561,89565,4763,2745,62,09028,105 5,52,722        27,636
2365,47662,3644,7492375,52,72227,636 5,43,510        27,175
244,7494,8685,43,51085,132 4,76,495        23,825
254,76,49590,000 4,02,378        20,119
264,02,37890,000 3,25,791        16,290
273,25,79190,000 2,46,651        12,333
282,46,65190,000 1,64,872          8,244
291,64,87290,000    80,368          4,018
3080,36883,047                –                    –  

 

Debt Avalanche Method
 Loan 1Loan 2Loan 3
 O/S at the beginning of the monthMonthly PaymentO/S at the end of monthO/S at the beginning of the monthMonthly PaymentO/S at the end of  the monthMinimum Payment next monthO/S at the beginning of the monthMonthly PaymentO/S at the end of monthMinimum 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.

  1. 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.
  2. 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

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