If you’re anything like the average American, your family is probably carrying somewhere close to $10k in credit card debt. For some of you, this number may even be (substantially) higher.
Making the decision to tackle that high-interest debt once and for all is the first step toward transforming your finances forever. Knowing where to start, though, and the best approach to paying off those balances can be tricky.
For example, do you agree with the legions of Dave Ramsey followers, and use the debt snowball method? Do you take the less popular –but perhaps more fiscally responsible – debt avalanche route? More importantly, do you even know the difference between the two?
Let’s take a look at each of these credit card debt payoff methods to determine which one best suits your needs. You may end up saving yourself a lot of money in the long run.
The Debt Snowball
Regularly promoted by Dave Ramsey himself, the debt snowball is a strategic balance payoff method. It is designed to help you “build up” the payoff impact as you go along. You know, like rolling a snowball around the yard.
If you’re at all familiar with Ramsey’s baby steps, you’ve heard of the snowball before. In fact, it’s step 2 of his system. Here’s the general idea behind the method, though:
Step 1: Gather Debts and Arrange from Smallest to Largest
The first part of the debt snowball is figuring out your debts. Once you have them all collected (with the exception of your mortgage), lay them out on paper. You’ll want to arrange them in order from the smallest balance to largest balance. You should also note the minimum payment due each month for each.
With this method, you should ignore interest rates on these debts.
For calculation purposes, let’s say that your debts are spread across four credit cards. We’ll note the interest rates here, but don’t pay attention to them until later.
- CC#1, balance: $900 (interest rate: 11%), minimum monthly payment: $50
- CC#2, balance: $2,100 (interest rate: 5.5%), minimum monthly payment: $44
- CC#3, balance: $6,650 (interest rate: 21%), minimum monthly payment: $137
- CC#4, balance: $7,500 (interest rate: 15.75%), minimum monthly payment: $219
Holding over $17k in credit card debt would be enough to keep anyone up at night.
In fact, if you only paid those minimum payments, it would be a whopping 110 months before you would be completely out of debt. Plus, your total interest paid over those 9+ years would be $11,191.34.
That’s a lot of sleepless nights and a lot of wasted money.
Step 2: Calculate How Much You Can Pay
If you just go off of the minimum monthly payments required by each of these four cards, you’re looking at $450 a month. That’s $450 each month that you could be investing, setting aside for the kids’ college expenses, or using for a family vacation. Instead, that money is allocated toward these balances and their constantly-accruing interest.
Now you see why debt can be so expensive.
Step two is where you take an honest look at your budget and decide how much further you can tighten the belt. Could you trim a little off of the grocery bill, in order to put $475 toward those credit cards? Maybe you could work to cut utility expenses, too, for an even $500? Or, if you’re really committed, trade in that newer, financed car for something less expensive.
Before you know it, you might figure out that as much as $600 a month could go toward aggressively paying down debts. (Let’s go ahead and use that number for our example.)
Step 3: Pay Off Minimums Due, Except for the Smallest Debt
Now, take all four of those credit card debts, and pay the minimum balance due each month. You already know that this adds up to $450 a month.
What about the extra $150 a month that you managed to squeeze out of the budget? Put that money toward your smallest balance debt, for a total monthly payment of $200 on credit card #1.
If you’d continued paying that $50 minimum each month, it would have taken you 20 months to pay off the card. However, with the added $150 going toward the pay-down, you’ll clear that entire balance in a quick 5 months. Wow!
This is where Dave Ramsey’s method really shines. Seeing your debts get quickly eliminated, one by one, is extremely motivating. Instead of spreading that $150 out across all four cards and feeling like you’re getting nowhere fast, you’re closing out an entire balance in less than half a year.
For many people, this can be all the motivation they need to stay on track and keep working toward becoming debt-free.
Step 4: Close Out One, Move to the Next
Once you’ve paid off that smallest balance, it’s time to refocus your efforts.
You’re now left with three credit card balances. The $200 that you were putting toward credit card #1 should be redirected to the next smallest balance, credit card #2. Now, instead of paying $44 a month, you’ll be sending $244 to that company.
Keep paying only the minimum due on cards 3 and 4, however.
Once you pay off card #2, take that entire $244 monthly payment and allocate it to the next card on the list: card #3.
Eventually, you will have all but one balance remaining, and you can devote your entire $600 debt-payoff budget toward this single card. When talking about paying off high-interest debts, $600 a month goes a lot further than $219.
You’ll have the balance cleared before you know it, and will have had multiple little victories along the way to encourage your progress.
How Much Will It Cost You?
Remember in step 1, where I mentioned that paying only the minimum payments each month would result in 110 months before becoming debt-free and a whopping $11,191.34 in interest paid alone? Well, let’s use an online calculator to see how this debt snowball method measures up.
By adding $150 extra toward your debt payments each month, you would shave off 6 years, becoming debt-free in just over 3 years.
By focusing on the smallest debt and then snowballing your efforts as you move along, you’ll also reduce that total interest payout from $11,191 to only $5,423.
That’s a savings of $5,768 and 72 months. Woo hoo!
The Debt Avalanche
Dave Ramsey is a big money figure for a reason: he motivates people. He encourages them to establish emergency funds, get out of debt, and helps them figure out their financial priorities.
As I mentioned, this is why the debt snowball works so well. People are motivated by these little success milestones along the way, and it keeps them chugging along. But, the debt snowball has its faults.
With the debt snowball, you’re focusing on the smallest debt balance, regardless of the interest rate. This means that, depending on your unique debt configuration, you could wind up allowing a high balance to sit around collecting a high interest rate.
If that debt is costing significantly more interest than your smallest debt, you could be wasting quite a bit of money by using the snowball method.
Enter, the debt avalanche.
With the avalanche method, you will instead be focusing on the interest rates. Highest and lowest total balances don’t even matter here – we are going for the absolute smallest payout that we can get away with.
After all, every penny saved is a penny that you can put toward your emergency fund or that you can invest.
So, how does it work and how does it measure up?
Step 1: Gather Debts and Arrange from Largest to Smallest Interest Rate
Again, we’ll be gathering our outstanding debts and arranging them. With the avalanche method, though, we’ll be focusing on the highest interest rate instead of the lowest balance.
Here are those numbers again:
· CC#3, balance: $6,650 (interest rate: 21%), minimum monthly payment: $137
· CC#4, balance: $7,500 (interest rate: 15.75%), minimum monthly payment: $219
· CC#1, balance: $900 (interest rate: 11%), minimum monthly payment: $50
· CC#2, balance: $2,100 (interest rate: 5.5%), minimum monthly payment: $44
Step 2: Calculate How Much You Can Pay
In case you need refreshing, the minimum amount due across all four cards is $450 a month.
However, by establishing a bare bones budget or just cutting out some unnecessary expenses, we’ve determined that we can actually contribute a total of $600 towards paying down these debts. The extra $150 a month will go a long way.
Step 3: Pay Off Minimums Due, Except for the Largest Interest Rate Debt
Once again, you’ll pay off the minimum amount due for three of the debts. For the fourth, however, you’ll put the extra $150 a month toward paying down that balance.
In our example, this is credit card #3. Instead of paying the minimum due of $137, you’ll instead be sending in $287.
By paying just the minimum payment due, this card would have originally taken you 110 months to pay off. Yes, that’s over nine years of your life that you would be dealing with this same balance. Ouch.
However, with the avalanche method, you’ll now pay this card off in just 21 months.
No, you won’t be getting that same gratification that you would have with the snowball method, where you were closing out a balance in 5 short months. However, you will get the joy of spending less money in the end toward that balance’s interest. And that should make you very happy.
Step 4: Close Out One, Move to the Next
Same rule as before: once you’ve paid off that first, highest-interest balance, it’s time to refocus your efforts.
You’ll now take the total that you were putting toward card #3 each month ($287), and focusing it toward the next highest interest rate on the list. For us, this would be card #4. Our monthly payment on that balance will now jump from $219 to $506, which will make a nice dent on the debt.
Keep repeating the process until you’re down to only one debt: card #2. Then, put the entire $600 a month toward whatever is left on that balance, until it is paid off in full and you, my friend, are officially debt-free.
How Much Will It Cost You?
Let’s revisit our original stats: paying only the minimum payments each month would result in 110 months before becoming debt-free and a whopping $11,191.34 in interest paid. Using the same online calculator, let’s see how the debt avalanche method measures up.
By adding $150 extra toward your debt payments each month in the avalanche configuration, you will still shave off 6 years, becoming debt-free in just over 3 years… actually, one month sooner than you would have with the snowball method. However, it will take you a bit longer to pay off your first account (21 months versus only 5).
By focusing on the highest interest rate debt and then compounding your efforts as you move along, though, you’ll reduce your total interest payout from $11,191 to only $4,509.
That means that the debt avalanche results in a total savings of $6,682 and 73 months. And that, my friends, is a win in the avalanche column, saving you $913 more than the snowball method.
Which Is Really Better?
While you can clearly see that the debt avalanche method will save you both time and money, that doesn’t necessarily mean it’s the method you should go with. In fact, the only method you should ever choose is the one that you’ll truly stick with.
If you’re the type of person who gets discouraged or is downtrodden about their debt, you may really need the debt snowball to give you nudges of encouragement. It can feel like you’re trying to run through mud sometimes when paying off debt – seeing that $900 card completely paid off can feel a lot more gratifying than seeing your $2,100 balance drop to $1,200.
If you need the motivation, go with the snowball.
However, if you’re the type who is driven to pay off your debt and you simply want to do it in the most cost-effective way possible, you’ll probably want to go with the avalanche method. Use our calculator to compare the two and see how much you’ll really save in the long run. This may be all the motivation you need to stay the course.
What if you really want to make this debt payoff as affordable as possible? Well, you may want to combine the two methods.
Depending on your exact debt configuration, balance transfers combined with the two payoff methods may be your best route. For example, if you pay off credit cards 1 and 2 (for a total of $3,000 in available credit and interest rates of 11% and 5.5%, respectively), it may make sense to transfer $3,000 of your debt on card 3 (holding a 21% interest rate).
While you’re working to pay off that card and focusing your payoff efforts there, you’ll also be accruing less interest. That means more money in your pocket in the end.
You will want to watch out for balance transfer fees, however. These are typically around 3% — though fee-free cards do exist — and could eat into your savings.
You may need to spend a few nights crunching numbers, but there are ways to optimize the “snowball vs avalanche” argument even further.
Whichever get-out-of-debt option you choose, make sure it’s one you’ll commit yourself to. Squeeze every extra dollar out of your monthly budget, and put it toward paying down those debts.
Once you are finally on the other side and out of debt – spending that $600 on yourself and your investments instead of credit card interest – you’ll be so glad you did.