Which Repayment Plan Wins: Debt Avalanche or Snowball?

MNP's TAKE: If you're like most Canadians today, you might find you're struggling to keep up with the day-to-day cost of living. With a weakened economy and unemployment on the rise, many people across the country have found themselves relying on debt to make it from one financial obligation to the next. While credit can be a helpful resource in a pinch, credit reliance can happen quickly, putting you in a cycle of debt repayments that can seem impossible to get out of. 

In times like these, the idea of setting aside funds for savings or creating a debt repayment plan may sound impossible. But taking the time to create a detailed budget that takes savings and debt repayment into account could prevent you from getting caught in the spin cycle of debt, while also ensuring you have a financial buffer set aside for any financial surprises the future might bring. Our Licensed Insolvency Trustees typically advise following the ‘debt avalanche approach’ described below, which involves paying down high-interest debt first. This ensures that the bulk of your payments are going directly to your debt instead of hefty interest charges. With that being said, at the end of the day if you have created a comprehensive budget and are making a concerted effort to not only set aside savings but also pay down your debt - you are certainly on the right track!  

If debt has already started to take hold and you feel trapped, you have options. Depending on your unique position, there may be several options available to help you on track to achieving a fresh financial start so you can get back to studying. Contact Grant Bazian, CIRP, President of MNP Ltd. at 778-374-2108 or [email protected] for information on what debt solutions are available to help you.

BY ROB ENGEN FROM THE TORONTO STAR

Many people want to know how to pay off their debts faster and save money on interest payments.

Two popular repayment strategies are called the debt snowball and the debt avalanche. We'll look at each method and apply it to a fictional family that has several different loans with various balances and interest rates, as well as an extra $2,000 per month to help pay down their debts faster.

First, how much do they owe? Here's a list of their types of debt, balances, interest rates and minimum monthly payments:

• Bank credit card: $3,800 balance, 11.99-per-cent interest, $76 minimum payment.
• Store credit card: $6,500; 29.99 per cent; $195.
• Student loan: $18,000; 5.00 per cent; $360.
• Consolidation loan: $22,500; 8.00 per cent; $450.
• Car loan No. 1: $24,000; 2.99 per cent; $480.
• Car loan No. 2: $36,000; 1.99 per cent; $720.

The debt snowball

This payment strategy focuses on the psychological advantage that comes from making progress with quick, successive wins. Here's how it works:

Start by arranging your debts from lowest balance to highest. It feels better to rid yourself of your smallest debt and the idea is that the snowball effect builds enough momentum that you'll be more inclined to stick with the strategy.

The following example shows how the family would use a snowball approach to tackle their debt. Every extra dollar is directed toward the debt with the lowest balance until it's paid off. Then, repeat with the next lowest-balance debt while paying the minimum on other loans.

A monthly payment of $4,281 would break down like this:

Bank credit card: Two months to pay off; paid off by November 2016 with total interest of $55.58.

Store credit card: Five months to pay off; paid off by February 2017 with total interest of $609.35.

Student loan: 12 months to pay off; paid off by September 2017 with total interest of $624.16.

Consolidation loan: 18 months t o pay off; paid off by March 2018 with total interest of $2,036.75.

Car loan No. 1: 23 months to pay off; paid off by August 2018 with total interest of $1,012.18.

Car loan No. 2: 28 months to pay off; paid off by January 2019 with total interest of $1,169.53.

Total interest paid: $5,507.55

The debt avalanche

This method suggests that math trumps behaviour. The idea is that you'll pay less interest and become debt-free faster when you attack your highest-interest debts first.

With a debt avalanche, simply list your debts from highest interest rate to lowest - regardless of the balance or minimum payments due.

Direct all of your extra cash toward your highest-interest-rate debt while maintaining the minimum payments on the other loans on your list. A monthly payment of $4,281 would break down like this:

Store credit card: Four months to pay off; paid off by January 2017 with total interest of $339.89.

Bank credit card: Five months to pay off; paid off by February 2017 with total interest of $166.62.

Consolidation loan: 13 months to pay off; paid off by October 2017 with total interest of $1,330.57.

Student loan: 18 months to pay off; paid off by March 2018 with total interest of $1,034.88.

Car loan No. 1: 23 months to pay off; paid off by August 2018 with total interest of $1,006.50.

Car loan No. 2: 28 months to pay off; paid off by January 2019 with total interest of $1,165.71.

Total interest paid: $5,044.17

The verdict

Whether they use the debt avalanche or debt snowball method, this family will become debt-free in 28 months. The biggest difference is that they're able to save $463 by tackling their highest-interest debts first.

The debt avalanche is the clear winner.

Math doesn't always trump behaviour, however. If you're the type of person who gets motivated by smaller wins, consider the debt snowball approach.

If you're all about paying the least amount of interest, go with the debt avalanche.

This article was written by Robb Engen from The Toronto Star and was legally licensed through the NewsCred publisher network.