The Debt Snowball v. The Debt Avalanche
How to smartly prioritize your debts.
There are two competing schools of thought when it comes to paying off debt.
The first, the debt snowball method, says you should pay off your smallest debts first regardless of interest rate. This gives you a psychological win by decreasing the overall number of debt accounts you have. Four credit cards with debt on them may be less stressful than five. Smaller balances are also easier to handle and can feel less overwhelming. This will theoretically help motivate you to pay down all your debt.
The debt avalanche method, on the other hand, takes a cold, hard look at the numbers and tells you to focus on the highest interest rate debts first. This makes more sense mathematically. If you have a credit card with a high interest rate, you want to eliminate it as soon as possible to avoid accruing more debt.
Both of these methods usually ignore mortgages, which are unique among debts in that they’re often large and have the lowest interest rates. They also assume that you still make the minimum payments on all your debts to avoid additional penalties.
To illustrate, let’s use an example. Imagine you have the following debts:
A credit card with $10,000 at a 24% interest rate
A credit card with $8,000 at a 12% interest rate
A car loan with $7,000 at a 5% interest rate
The debt snowball method would tell you to pay off the car loan first, as it’s the smallest debt. The debt avalanche method on the other hand would tell you to prioritize the credit card with the $10,000 balance, as it has the largest interest rate and will accrue debt the fastest.
These two methods of paying off debt have their true believers. So which one should you use?
If the psychological boost of paying off a small debt, even if the interest rate is also small, is what motivates you to stay on track, it may be the approach you need. But you also shouldn’t ignore interest rates, especially when it comes to credit cards, which have some of the highest. Even a small debt with a high interest rate can quickly eclipse some of your larger debts that have a lower interest rate if your priorities are misplaced.
This gets to another issue: Not all debt is created equal. If we were ranking debt from “good” to “bad,” we might list a mortgage as good debt and credit card debt as bad debt, with things like car loans and student loans somewhere in between.
If you have a mortgage, it’s probably the biggest debt you have. It also probably has the smallest interest rate, especially if you bought a home or refinanced in 2020 or 2021 when rates were lowest. A mortgage is the very last thing you should pay off, as it makes little sense to pay off a debt with a low (probably fixed) interest rate early, especially when you can get a higher rate of return by investing your extra money each month.
Credit card balances tend to be smaller, but with high interest rates, they can be the most disastrous financially. And if you fail to make the minimum payments each month, you can end up paying additional penalties. Payday loans can be even worse offenders. While you should avoid them completely if possible, they should be priority number one for paying off.
Viewing all debt as equally bad can only end up making your situation worse. Most people couldn’t afford their homes if they were forced to save every penny for them. But most of the items people pay for with a credit card can be saved for within reason.
None of this is to say you need to stick strictly to one or the other. You could try a combination of the two strategies in which you initially pay off some of your smallest debts regardless of interest rate to get that psychological boost that comes from reducing your total accounts. Then you shift toward the more mathematically sound strategy and tackle your highest interest rate debts to keep your debt from spiraling out of control.
While approaching debt payoff from a purely mathematical standpoint is the most logical, money is highly psychological. Using the debt avalanche can be demoralizing, and if that keeps you from finishing the job, it defeats the purpose, which is to be debt-free. Getting small wins at the beginning can motivate you to continue.
Ultimately, you should pursue the strategy that will get the job done. Because once you’re out of debt, you can dedicate your free cash flow to building wealth full time.