Snowball vs. Avalanche Debt Paydown Method
One of the first financial "gurus" that people often tell me about is Dave Ramsey. For the uninitiated, Dave Ramsey is a financial author and talk show host who popularized his snowball method in his book, The Total Money Makeover. And he has had quite the impact on the financial services community by provided Dave Ramsey preferred financial coach partners, where a financial coach can go through his training and pay to get prospects fed to them.
What is the Snowball Method?
The Snowball Method is a process to eliminate debt. Simple right? What it recommends is to write out and track all of your debt in terms of monetary value owed at the present time. After doing this, we must order the debt in terms of increasing value. And finally, pay off this debt by paying off the smallest balances first.
Now, why does this work? it works on the principle of having many small victories over your financial chains. After paying off each debt completely, it feels like a moment of relief as if you have won the first battle. And this continues to fuel your drive to pay off the next smallest debt. Repeat this over and over until your debt is completely paid off.
Largely, it gives you the motivation to continue to pay off the debt by giving you small victories and increasing the chances of the feel-good hormone to make you more likely to tackle the next debt. This is why it is called the Snowball Method. It continually builds up until the snowball becomes so large from paying off debt, that it fast tracks you into building more wealth through the next stage: investments.
But, Justin, is this the most efficient method?
No. The reason why this is absolutely not the most efficient method is that the smallest debt might not have the highest interest rate.
So, let me explain:
Say you have two separate debts. One is 10,000 at a 15% interest rate and the other is 1,000 at a 10% interest rate. What the Snowball Method recommends is to take care of the 1,000 first, and worry about the 10,000 later. But this doesn't make numerical sense. For simplicity, let's assume that the interest is billed on an annual basis. This means that 10,000 will be 11,500 in one year, whereas 1000 will only grow to 1100. So in one year, by not trying to pay off the higher interest rate, it grew by over 1,000...more than the other debt completely.
So why doesn't everyone just pay off high-interest debt first? I mean technically, it's the most efficient method. But paying off high-interest debt first may not lead to the small victories that the Snowball Method would give. And thus, people are more likely to give up on paying it off.
So while it is the most efficient, psychologically, many people prefer the Snowball Method as it gives them something to celebrate about at smaller terms rather than tackling the most expensive and fastest-growing debt.
So, what does this mean for me?
Choose the method that works for you. For me, I rather be efficient as I tend to see things in the long term. For many others (likely the majority), the Snowball Method will give each person victories that they can use as motivation for the next battle.
You have to know what kind of person you are and choose the best method for you because, at the end of the day, all that truly matters is that you pay off your debt and free your financial chains. You are in control.
Live intentionally.