Which debt should I pay first?
When choosing between more than one debt, there are two common schools of thought on repaying debt. One school is adamant that the best method is to pay down the highest interest debt first – called the debt avalanche. The other school is adamant that paying the smallest debt is best – this is called the debt snowball.
Jim has 3 loans:
1/. Car loan of $8,000 at an interest rate of 8%
2/. Credit card loan of $10,000 at an interest rate of 15%
3/. Student loan of $40,000 at an interest rate of 4.4%
Using the debt avalanche theory, Jim would pay off the $58,000 in debts in order of highest interest rate to the lowest. Credit card loan would be paid off first. Once this was completely paid off, he would attack the car loan debt. Once the car loan had been wiped, he would finally pay off the lowest interest debt of the student loan.
If Jim had an extra $400 a month to contribute to his debt repayment plan, he would be out of debt in just under 8.6 years. Total amount of interest paid of $13,827.
Attached below is a nifty Excel based debt avalanche calculator I created for you to check out. Just enter your loan data on sheet one labelled 'enter loan data' and Bob's your uncle.
This time Jim has the same loan debt, except he repays the debt in order of smallest debt to largest. In this case, the car loan would be paid off first. Credit card second, and student loan last.
If Jim had an extra $400 a month to contribute to his debt repayment plan, he would be out of debt in just under 9.4 years. Total amount of interest paid of $17,137.
Here is a snowball calculator for you to download:
AVALANCHE VS SNOWBALL
So, which one comes out on top in this scenario? It depends. Don’t you just love when someone answers with it depends? You just want the straight answer. Sorry about that, but it really does.
If we are looking at the results from a purely mathematical point of view, then the avalanche method of repaying the highest interest debt first is better. We have saved ourselves 9 months and $3,310, than if we were to follow the snowball repayment method. If we were to extrapolate the $400 we were using on debt repayment to savings for the extra 9 months we got, then the total difference would be about $7,000 over 9 years. Looks like a clear winner right?
Maybe not. It depends on our relationship with money. For someone that is comfortable with saving money and is able to budget, then the avalanche will be the best method. But for someone that is not good with money, snowball may be the way to go.
In the example above, the first loan took 31 months to repay. This is a very long time to see a win. Someone who is not so good with their money is likely to give up well before this point. Using the snowball method, the first loan is paid off in just 16 months. About half the timeframe. The shorter timeframe may be enough to have this person stick to it. Then once it is paid off, they have now built up the motivation and encouragement needed to continue with the other loans. They would not have got this same feeling using the avalanche repayment method.
It all comes down to what works best for us and our situation that will result in the best chance of sticking to the repayment plan. It could even be a hybrid of the 2 plans. It doesn’t have to be one or the other as many would have us believe. We can split up the $400 so that some goes to the highest interest rate and some goes to the smallest loan.
Is the loan secured or unsecured? A secured loan, such as a car loan carries more risk. It basically means, if we don’t keep up with repayments then the lender can take ownership of the car. Our car is put up as security against the loan. Most credit card loans are unsecured, but do check the fine print of your agreement. We can stand to lose more with secured loans. This is why most unsecured loans are more expensive than secured loans. Because the risk is transferred from the borrower to the lender.
Is the interest rate on your repayments likely to change? No one can predict the future but we can take a reasonable guess. The interest rate payable on a car is generally fixed at a certain rate for a certain amount of time. It won’t go up or down. There is certainty of payment. With a credit card loan though, we are at the mercy of the lender. They can change the interest rates as they please, and it will very rarely be down. With uncertain loans like this, it may be a good idea to prioritise repayment here.
Will you be penalised for making early repayments? Some agreements don’t allow us to make extra payments. Or if they do, they don’t allow us to reduce the length of the loan. Read the fine print of your agreement before you decide to make any extra contributions. There may be a set limit. In essence, the interest we pay may be less, but the term of our loan could still be the same.
Can you get a lower interest rate? It is commonplace to switch credit card companies now. We can take our balance from a higher interest loan, and transfer it to another company at a lower rate. This could save us a lot of money over time. Just make sure that you read the terms and conditions of your new provider, as your new minimum payments may be higher and you don’t want to miss those. You will also need to throw away your old card for this plan to work. Or maybe you can pay for your car from your mortgage account. You are likely to get a lower rate than if you were to get a specialised loan.
There are advocates that sternly defend the debt avalanche, and just as many that defend the debt snowball. There is no right or wrong answer here. The decision may be about the numbers for some. For others it may be more about gaining momentum or minimising risk. Personal finance is PERSONAL. What is best for me, is not best for you. Find what works for you and roll with it (snowball pun intended).
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here
Chime into the conversation with your comments? Do you have a favourite method of repaying debt?