The Avalanche Method for Debt Reduction

Say your monthly income is $4,000. Last month you spent $4,100 on living expenses and minimum debt repayments, so you incurred a shortfall of $100. Maybe you put that $100 onto a credit card. If you follow the same spending pattern this month and next month, you won’t repay your debts. The key is to reduce spending to below your income. You look through last month’s bills and figure that, if you really set your mind to it, you could cut your spending down to $3,700. If you manage this, you’ll make a monthly surplus of $300 ($4,000 less $3,700).

You then use your monthly surplus to make extra payments against your debts. Bear in mind, these payments are extra in the sense that (unless your creditors have agreed otherwise) you must make monthly minimum payments against each debt. And these minimum payments are included in your $3,700.

Once you’ve paid off the first debt, you no longer need to make minimum monthly repayments on it. If your monthly minimum on that debt was $20, your $300 monthly surplus now increases to $320.

But here’s the question. If you have more than one debt, which one should you pay off first? In an ideal world, your smallest debt would be the one with the highest interest charge. That would make things easy. Paying it first would be a no-brainer. But what if your smallest debt is the cheapest?

For example, maybe you owe the following consumer debts:

• $5,000 on credit card A – which charges interest at 3% per month
• $2,000 on credit card B – which charges interest at 1% per month
• $1,000 to a furniture store – interest free

With debt snowball, you pay off the lowest debt first. In this case, you put your $300 surplus against the $1,000 store debt, and you’ll do the same every month until you pay it off. Then you’ll move on to the $2,000 debt.

With debt avalanche, you’ll put your $300 against the $5,000 debt. Once you’ve paid it off, you’ll tackle the $2,000 debt and then, finally, the store debt.

If we had computer brains, the avalanche method of debt reduction would make total sense. Paying off credit card A will minimise our interest charges. Surely that’s a good thing? Surely it’s logical to reduce the debt on which we’re suffering 3% interest every month, particularly if we’re getting an interest-free loan from the furniture store?

Yes, debt avalanche is logical. But the snowball method claims two advantages:

• With snowball, you’ll pay off your first debt more quickly – and crossing a debt off your list is motivating. You gain momentum and that makes it easier to keep going with your monthly budgeting.
• Also, snowball is simple from day one. You don’t need to figure out the interest charge on each debt. All you need to know is the outstanding balance. Whenever we want to develop a new habit (like paying off our debts), keeping things simple is a really important factor.

I’m tempted to say accountants – or at least those people who favour logic in their decision-making. Imagine that tackling the highest interest debts first would save you $1,000 or more in interest charges. Isn’t that idea sufficiently motivating? Why pay an extra $1,000 (or whatever you calculate the figure to be) in total interest just to be able to clear a cheaper and smaller debt quicker. Sure, it’s nice to cross debts off your list, but really, $1,000…

I am an accountant by training, and I appreciate this argument. That said, I’ve been imagining what I would do if I had multiple debts to pay off. Which strategy would I prefer?

I think I’d go for the snowball method of debt reduction because, in addition to being an accountant, I’ve spent a lot of time researching how to achieve personal and financial goals. What really makes a difference, for me, isn’t cold logic. It’s consistent action day by day, weekly, monthly, long-term.

Getting started on any new habit is a huge challenge. Even in that initial burst of enthusiasm, it’s important to keep things simple so we take action today. The avalanche method for debt reduction is logical as regards long-term saving. But for me, the snowball method is more logical as a way of kickstarting and maintaining a new habit of paying off debts.

The only important question for you is this. Which method would most likely help you take action to repay your debts?