Over the past few weeks, we’ve been answering some questions around money, specifically personal finance. We discussed how you could talk to children about money, we gave you some tips on when you should sell an investment, and we analysed how much you should be saving.
These topics are great, but they assume you are able to save, and invest. What if you are unable to put money aside to invest, maybe because you’re paying off debt?
That was a question a reader recently asked: Nina has a car loan, a credit card, and student loans. She worries about her debt.
Leon Zeng, director of behavioural insights at Morningstar, say this is natural: “Debt might sound like a scary burden to regular consumers, but it would be less scary if we could reframe it as a financial tool to help obtain needed assets and pay it back over time in a more manageable way.”
Morningstar’s director of personal finance Christine Benz points out that it’s important to remember that debt paydown offers a guaranteed "return on investment" equivalent to whatever your interest rate is. And paying down debt also means you're less likely to be over-leveraged financial, which could lead to mental stress.
Nina agrees and wants to make sure her debt is manageable, so she asked if we had any ideas about how she should go about repaying her debt. She specifically asked if a "debt avalanche" or a "debt snowball" is the better option.
Let’s start by understanding what these terms mean.
Where to Begin?
“One of the best first steps you can take is to reduce your interest rate or buy yourself some time before your interest starts racking up,” says Benz. Many banks offer balance-transfer credit cards with 1% introductory rates for a certain period, usually 12 to 18 months, and she suggests using that grace period to turbo-charge your debt paydown. With low or even 0% interest, all of your payments go directly on reducing your outstanding balance. “Just be sure to check the fees associated with the card; there may be charges to transfer your balance,” adds Benz.
If you’re thinking of paying off your debts as fast as possible, the initial steps you take are the same: list out how much you owe, to whom, over what time period, and at what interest rate.
In Nina’s case, she owes:
- £9,000 in credit card debt at 19.99%
- £6,500 in a car loan at 3.5%
- £11,000 in government and private student loans at around 3%
Now that you have all the details written out, it’s time to look at the two methods of repaying your debt.
With the debt avalanche method, you make minimum payments on ALL debts. Then, any money that you have left over is thrown into repaying the debt with the highest rate of interest. Once you finish paying that one off, you move to the next-highest interest rate loan. And then the next, until all your debts are paid off.
In the avalanche method, Nina would start by paying off her credit card, then move to the car loan, and finally pay off her “cheapest” student loans.
Meanwhile, in the debt snowball method, you list your debts from smallest to largest, make minimum payments on ALL debts, and then put all the extra cash you have towards paying off the smallest debt first. Once that is paid off, you move to the next one, and the next, until you’re debt free.
With the snowball method, Nina would start by paying off the car loan, then move onto credit card debt, and finally tackle the student loans.
But which is better?
Do the Maths
“Financially and theoretically, it is always better to pay off the highest interest rate debt first (i.e., the debt avalanche approach), because reducing the total amount of interest-paying liability benefits the investor from the mathematical perspective when considering the total payment to clear the debt,” Zeng says.
Morningstar’s director of personal finance Christine Benz agrees, adding that “the math certainly favours the avalanche, in that you're wiping out high-rate debt first and that debt is the costliest”. She adds that getting rid of high-interest debt should typically be near the top of anyone's funding queue. After all, there's no way you can beat a double-digit return by investing in anything else that's guaranteed.
Debt is More than Money
However, Zeng points out that debt is often about more than money: “Debt management is not only a financial/mathematical issue, but also a psychological one. Some long overdue small debt might trigger repeated collection calls or even legal actions from creditors, and thus the debt avalanche approach might not always lead to the best result in reality.”
Benz notes that the math doesn't favour the snowball method, in that paying off high-interest-rate debt will always deliver more of a payoff than lower-interest debt. “But if this strategy incentivises someone to become debt-free, it's hard to be a naysayer!” she says. “Anyone who has ever tried to tackle a daunting task – whether cleaning up a house after a dinner party or tackling a large project at work – knows that there's great power in just taking those first small steps.” In this way, the debt snowball is kind of a behavioural trick, the idea being that taking small steps can lead to a sense of motivation and empowerment. In this case, the creditor wipes out the smallest debts first, regardless of interest rate, and feels empowered by clearing one tranche of their debt.
“In reality, many consumers try to pay off the smallest debt first to get a sense of control, further a sense of achievement, and even more practically to stop repeated collection calls from creditors to get peace of mind,” Zeng adds.
There is no direct formula or “right” answer here. Debt and money are deeply personal, and only you can decide your relationship with your money.
“The benefits of behavioural strategies like the snowball can't really be measured in numbers. The math favours the avalanche approach, but if the snowball helps someone actually achieve the goal of being debt-free, there's value in that, too,” Benz says.