One of the personal finance follies that gets me fired up is the debt snowball method and the proponents who push it as the ideal way to pay off debt.
This is the debt repayment method where you list your debts smallest to largest and, while minimum payments are made on all debts, all excess payoff proceeds are put to the smallest debt first, irrespective of interest rate, in order to pay it off first and build a “debt snowball” which gains momentum as these smaller debts are paid off working up until finally paying off the largest debt. The proponents cite psychological reasons for the approach (not common sense or logic!).
The issue here is that this is inefficient. Wake up! If you are really serious about paying off your debt, always begin by paying off the highest interest rate debt first (after making minimum payments on all debt). This is the best method of paying off debt, and frequently called the debt avalanche method.
Let’s take a simple example of 2 debt amounts as follows:
Debt A: $8,000 at 10%, $100 per month minimum payment
Debt B: $2,000 at 5%, $20 per month minimum payment
Assume this person has $500 per month available to pay off debt, thus $380 extra after minimum payments are made.
Following the debt snowball approach, all $380 of extra cash flow after the minimum payments have been made is allocated to Debt B, even though Debt B has half the interest rate of Debt A. Not smart! As you can see below, this would result in $955 of interest over the 22 months of payments.
Following the debt avalanche approach, all $380 of extra cash available after the minimum payments have been made is instead allocated to Debt A, since it has the highest interest rate. Over the same 22 months of payments, this results in $809 of interest ($146 less!).
Final verdict, the debt snowball results in over 18% more interest expense over the same 22 months of payments. Clearly, the debt avalanche method saves you money!
Extrapolating this example to the debt size of the average American household of approximately $130,000+, with around $15,000+ of high interest rate credit card debt, and we’re talking about thousands in savings rather than hundreds! This should be all the motivation you need.
Be smart! Allocate extra funds available after minimum payments to pay off those higher interest rate balances first and bank those savings.