Snowball, Avalanche Method – or Hold?
Your interpretation of debt can make or break your financial future. I first want to say, as a very risk averse human being, I do not like debt. Debt is as much an emotional issue as a financial one and thus, I also like the peace of mind that being debt-free brings. The Bible also says to be a lender and not a borrower (Ie- be the bank and not the customer). Finally, there is a whole lot of data to prove that your best, first investment is in eradicating your debt.
All of that said, debt can provide value or leverage to the point where using your free-cash to reduce it could be very counterintuitive to generating wealth. As an easy-to-understand example, let’s discuss the debt in your home; your mortgage. Mortgage rates are relatively low these days at around 3-4%. Additionally, there are tax deductions on that mortgage interest you can take along with other deductions related to your home from your federal income tax. That makes the final mortgage interest rate even lower than 3-4%.
To over simplify, if you have a $250,000 mortgage and use cash to pay it off, you ultimately invested $250,000 at less than 3-4% interest (Argument; you’re no longer losing < 3-4% annually on that mortgage).
IF (emphasis on IF) you are a savvy or well-informed investor and could find a safe place for that money to be earning >6% interest, it ultimately makes little sense to have paid off the <3-4% interest loan. This is called “leverage,” you leveraged the bank’s money so you can do more with yours. Leverage is often used in real estate where rather than using available funds to buy 1 investment property, you use those funds as loan down payments on the bank’s money and buy 2-3 properties.
Again, I don’t like debt. If you do not have a good place to put money to make the >6% interest, then pay off the debt. Most debt is not leveraged, but just bad debt; so worth getting rid of.
Two common methods of eliminating debt:
The Snowball Approach
- Pay the minimum balance on each debt you have
- Add any money leftover to the smallest debt on the list.
- After paying off your smallest debt first, you move on to the next, and the next. Thus, the “Snowball effect.”
Example Snowball: Debts outstanding:
- MasterCard: $8,000
- Car: $10,000
- Student Loan: $40,000
- Boat: $4,500
As most people know, never buy a boat! It’s bad debt, so let’s get rid of it first.
With the snowball method, we focus on the boat – the smallest loan.
Minimum payments:
- MasterCard: $150
- Car: $300
- Student Loan: $200
- Boat: $250
We’re encumbered with $900 in monthly payments. Using the snowball method, you make the minimum payments on everything and as an example, have $400 leftover to put towards the boat ($1300 total for debt).
A year later, the boat is paid freeing up $650 a month that now goes towards the new smallest debt, the MasterCard.
The Avalanche Method
- This begins with the highest interest rate debt.
In our above example applied to Avalanche:
- MasterCard: 19%
- Car: 6%
- Boat: 4%
- Student Loan: 3%
You pay the minimum amounts, but this time we pay down credit card debt with leftover money since it’s the most aggressive, worst debt. Once the most expensive debt is paid off first, it then falls to the next; car loan, and so the debt rolls down like an avalanche.
In the Snowball method, you get rid of that bad boat debt quickly. In the Avalanche, it generally takes longer since it’s a bigger number, but you get rid of your worst debt.
There’s no one size fits all, but if you do not get the entirety of this paper in order; you’re sure to wake up financially unsatisfied in the years to come. Gained economic knowledge invested today reaps a harvest of wealth tomorrow.
Have fun saving the world!
Dr. Ben
