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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