Consumer debt payment: What are the snowball method and the avalanche method?
When paying off debt, there are two main approaches: the snowball and avalanche methods. We took a look at both to see where each would be more effective.
Household debt levels in the United States are climbing after reaching record lows during the pandemic.
Early in 2021, the delinquency rate on credit card loans hit 1.60 percent —the lowest recorded rate since 1992. However, as pandemic-related relief ended, the rate increased to just over two percent in 2022, still below the levels of late payments seen in 2019. A similar trend can be seen when examining data on the percent of disposable income the average household in the US spends on debt.
Debt payments as a percent of disposable income in the US
As more debt is taken on, understanding the different strategies to pay them down may strengthen the financial health of your household.
However, many financial advice websites neglect how difficult paying off debt is when it consumes an ever-increasing portion of your disposable income.
The hypothetical situations put forward by Investopedia are no doubt helpful in how they describe the two strategies but make unrealistic expectations about the income level a borrower may have. In their examples, a borrower would have $3,000 a month to pay toward their debts. If the average household spends nearly ten percent of its income on debt, the example assumes that the average borrower makes more than $300,000 a year.
For many, making minimum monthly payments is all that they can afford to do, and spending more of their disposable income on debt is not an option. Additionally, current US law allows for the minimum monthly payment to be lower than the interest accrued on a loan, meaning that while paying it back, the sum owed can grow.
The first approach we will examine is the snowball method which advises borrowers to pay off loans with the lowest principal balance first.
For instance, imagine a debt holder named Sally has an annual net income of $50,000 a year and sets aside 25 percent ($12,500) to pay off her debt and loans each month.
|Loan||Amount Owed||Interest Rate||Minimum Monthly Payment||Interst Accrued Annual (Monthly)|
|Student Loans||$2,500||6 percent||$234||$150 ($12.5)|
|Auto Loan||$7,000||5 percent||$700||$35 ($2.9)|
|Medical Debt||$500||4 percent||$50||$20 ($1.6)|
Based on Sally’s budget, she can spend around $1,041 paying down the amount she owes. The minimum payments bring her total owed to $984, leaving her around $64 to put towards paying down the principle balance of her loans.
The snowball method would advise that the medical debt be paid down first because it is the smallest loan of the bunch. Making the $50 minimum payment and allocating $64 towards this loan will allow Sally to pay her medical debt off in around four or five months.
Next, Sally would want to handle her student loan payments. Now the $50 from the medical debt can be applied to the student loan payments, which will allow her to increase her payment from $234 to $338, meaning the loan will be paid off in seven or eight months. Sally can now focus on her auto loan, put all $1,041 towards this effort, and will have it paid off within six to seven months. Based on this budget and the amount owed, Sally could be debt free anywhere from seventeen to nineteen months, depending on how much interest was accrued.
The avalanche approach differs in that it advises borrowers to pay down their debts with the highest principal balance and interest rate first.
In the case of Sally, this would begin tackling her debt with the auto loan, using the extra $64 towards this debt to pay it off in around nine months.
Then, Sally would take the same approach on her student loans, meaning that now she can use $998 towards that debt, allowing her to pay it off in two months. Lastly, she can pay the $500 medical bill in one month. Using this approach, Sally could become debt free in thirteen months. Based on the types of loans Sally owes, the debt avalanche strategy may be more conducive to her unique financial situation.