In our 2021 Financial Wellness Kickoff Survey, we asked our community of Branch users what they would do first if they got a bonus. The most popular option was “Put it into your checking account in case you need the money” (38%), followed by: “Pay off whatever debt amount is the highest amount” (32%). Only about a quarter (24%) of users said they would “Pay off whatever debt has the highest interest.”
There is no right or wrong answer to how you choose to spend your money. But there are some ways of dealing with debt that can actually save you more money in the long run. It turns out, the 24% of users who said they would pay off the debt with the highest interest rate first might be onto something. It’s known as the debt avalanche method: paying down your highest-interest debts first so you can save more money overall while also speeding up your debt-free date.
Let's use an example with some manageable numbers to understand how this works. Let’s say you get an extra $100 a month to pay down some of your debts. You can either put it towards your $250 credit card debt or your $250 student loan debt. Even if you owe the same amount for both debts ($250) you have to take into account that they have different interest rates. The credit card debt is costing you $25 a year while the student loan is costing you $2.50 a year. The credit card interest costs you 10 times as much as the student loan interest! In this case, paying your credit card debt off first saves you more money in the long run.
Debt Avalanche Method v. Debt Snowball Method
Now let’s look at a detailed example that compares the debt avalanche method to another method—the debt snowball method. The debt snowball method focuses on paying down the lowest debt figure first.
Let's say you have an extra $100 a month to pay down some of your debt and you can either put it towards your $500 credit card debt with 10% interest, or towards your $250 student loan with 1% interest. Keep in mind that not all interest is charged in the same way. So let’s shake things up a bit by treating interest as how it actually works. Now the interest is no longer annual interest but the interest rate you see on your credit card bill.
Let's look at the pros and cons of using the snowball vs. the avalanche method for this scenario. Which method should you choose?
Pros and Cons of Debt Snowball Method
Like a snowball rolling down the hill and picking up speed, the debt snowball method will start to show you quickly that you're making progress. This can be a highly motivating factor, but looks can be deceiving.
Pros and Cons of Debt Avalanche Method
The mighty avalanche takes a lot of power (willpower, in this case) but it also delivers dramatic results.
While paying down any debt is important, there's a clear winner if you want to save time and money. The debt snowball method may give you a sense of instant gratification, but the avalanche method has some clear advantages by saving you more money and time in the long run.
If you go with the avalanche method and pay off the debt with the highest interest rate first, it will only take 10 months and $248.16 of interest to pay the money off. That saves you $311.59 in interest and 4 months of paying towards your debt! So if you're like 32% of respondents who said they would pay down the debt with the highest amount first, you may want to join Team Avalanche and consider switching to paying the debt with the highest interest rate instead.
Sample Snowball Method Payment Plan
As you're learning, interest can accrue fast. Check out the charts below to see how the example we used above plays out month-by month.
Sample Avalanche Method Payment Plan
At the end of the day, you know yourself and your spending habits better than anyone else. Whether you choose the debt avalanche method, the debt snowball method, or another way of paying down your debt, the best thing you can do to become debt free is to keep making consistent payments and to stick to your goal!