FINANCIAL FRESHMAN #017
TL;DR → With the debt snowball method, progress may be felt more quickly since you’re focusing on the debt with the lowest balance. With the debt avalanche, that focus is instead placed on that debt with the highest interest rate. There are pros and cons to each, but remember not to let perfection get in the way of progress.
Ryan’s Student Loans
Let’s follow up with Ryan, our hypothetical college graduate that accepted a Supply Chain Analyst position that will pay $59,000 per year. Like millions of other graduates transitioning into the workforce, Ryan will have some student loan debt that is coming due. Using our write-up on taking a student loan inventory, Ryan knows he is faced with the following debts.
Remember that personal finance is personal. Getting out of debt is a very nuanced process, and you should be skeptical of any source that prescribes the “best” path forward.
In this article, we’ll begin to dissect how Ryan could approach the payback of his student loan debt. We’ll cover the debt snowball, the debt avalanche, and provide some reflection questions to understand which may be more appropriate for you.
Debt Snowball
When we calculated Ryan’s net income, it came out to be $37,645.06 per year, or $3,137.09 per month. To keep things simple, let’s assume he has room in his budget to dedicate $800 per month towards his student loans. We know that his total minimum monthly payment (MMP) is $590, but what should he do with the remaining $210? The debt snowball provides one option.
In the debt snowball, Ryan would focus solely on loan balance. After his MMPs are paid, all remaining available funds would go towards the loan with the smallest balance. In month 1, Ryan would pay the extra $210 towards Loan C. This process would continue every month, and any extra available funds would be applied to the loan with the smallest total balance. As loans are completely paid off, the corresponding minimum monthly payments can be snowballed into the excess payment of another loan.
Paying off the smallest balances first provides a psychological boost as you see debts eliminated quickly, which can help maintain motivation to stay on track. As you pay off smaller debts, you have fewer loans to manage as well, which will simplify your repayment process.
Debt Avalanche
Another common debt payback strategy is the debt avalanche. If instead following the avalanche method in month 1, Ryan would dedicate his extra $210 towards Loan E since it has the highest interest rate. This makes the debt avalanche the mathematically optimal payoff strategy, in terms of total cost. However, it may delay the feelings of progress that could come more quickly when following the debt snowball.
With this approach to debt payoff, there is one common misconception that is worth addressing directly. To explain, let’s first review Ryan’s student loan debt again. Note the new column, which is the current balance and the interest rate multiplied together.
Loan E is the debt with the largest interest rate, but it looks like Loan D is accruing interest more quickly due to the higher balance. Because of this, it may be common to think that extra funds should be targeted to Loan D, but that would not be minimizing total interest paid in the long run.
If this doesn’t make intuitive sense, instead think about Loans D and E as though they were broken into individual $100 debts. So, Ryan has 150 $100 debts at a 4.8% interest rate, and 90 $100 debts at a 7.5% interest rate. With our extra $210, we would obviously want to take care of two of the debts that are sitting at 7.5%.
Final Thoughts
So, how should you choose which is right for you? Consider a few questions to reflect on.
- Did the thought of seeing progress quickly give you a boost of energy?
- Are you worried about how much interest you’ll pay in the long run?
- Based on how much extra money you have left over, how quickly could you pay off your first debt with the snowball method?
- Will it be easy for you to manage all of your debts, and their corresponding minimum monthly payments?
- Do you have any debts that are significantly larger than the others?
These are all valid questions, and highlight how nuanced this decision can be. After a disciplined payoff with either of these approaches, you’ll find an adult life free of student loan debt. This Winston Churchill quote serves as a good reminder that simply getting started is where your priority should lie.
“Perfection is the enemy of progress.”
