En español | Digging out of debt is tough. Like a diet, it takes discipline and a plan. The measure of success, however, isn't losing weight; it's shedding unwanted debt that poses a threat to your financial health.
So what's the best way to escape the debt trap and get those account balances down to zero once and for all? Two popular debt-reduction strategies worth considering are the “debt snowball” and the “debt avalanche.”
The goal of both is straightforward and simple: becoming debt-free.
U.S. household debt hit a record $14.15 trillion in the fourth quarter of 2019, according to the Federal Reserve Bank of New York. Although mortgage debt of $9.56 trillion is the largest portion of debt Americans owe, credit card debt climbed 5.3 percent in the final three months of 2019, bringing owed balances on plastic to $930 billion. The average American household carries about $6,194 in revolving credit card debt, according to American Consumer Credit Counseling, citing data from credit-monitoring bureau Experian.
The snowball method focuses on eliminating your smallest debts first, while the avalanche approach places the highest priority on eliminating debt with the highest interest rate.
Here's a more detailed look at how these two common techniques work.
Popularized by personal finance expert Dave Ramsey, the snowball method is all about small victories on the way to total triumph. It's less about pure math and more about momentum, positive psychological nudges and, ultimately, behavior modification.
Simply put, the snowball method is when you pay off your debts in order of smallest to largest, “gaining momentum as you knock out each balance,” Ramsey explains on his website. “When the smallest debt is paid in full, you roll the money you were paying on that debt into the next smallest balance.”
Let's say you have a $500 Visa balance with a $25 minimum monthly payment, a $1,000 MasterCard balance with $50 due each month, a $1,500 hospital bill with $75 due monthly, and you owe $2,000, or $100 a month, to American Express. That's $5,000 in debt, which can seem insurmountable.
Dave Ramsey's debt snowball steps:
- List your debts (excluding your mortgage) from smallest to largest, regardless of interest rate.
- Make minimum payments on all your debts except the smallest.
- Pay as much as possible on your smallest debt.
- Repeat until each debt is paid in full.
Using the snowball method, you would pay only the minimum due on all your bills except for your Visa bill, as that has the smallest balance. Once you get your Visa account to a zero balance, you target the next-lowest balance, which is the MasterCard, while still making the minimum payments on your hospital bill and AmEx account.
Eventually, if you stick to this debt-reduction plan — and don't rack up fresh debt along the way — you'll be debt-free. Even better, you'll have a lot more cash at your disposal to invest, add to your emergency fund or simply sleep better at night.
Financial planners praise the snowball strategy because paying off any bill in full, even a small one, delivers a key motivational message that boosts the likelihood the consumer will stick to the plan: “I'm making progress.”
With the snowball method, “success is a series of small tasks completed in succession,” says Bryson Roof, investment adviser at Roof Advisory Group, a division of Fort Pitt Capital Group. “Paying off a small loan first is an accomplishment that can help fuel the next task.”
The next task, of course, is paying off the next bill with the lowest balance.
Even though the snowball technique doesn't reduce your interest expenses as fast as the avalanche method, it works well for people who like to see progress and symbols of accomplishment, no matter how small, says Daniel Milan, managing partner at Cornerstone Financial Services.
"There's a psychological advantage to the snowball method,” says Milan. “When you see a debt eliminated, you get a sense of immediate gratification.” And when your account statement arrives and it shows a zero balance, “there's that visual, and they say, ‘Oh, my God, I've made some progress.’ “
And success breeds more success, driven more by behavior modification than math.
"If you started the process with, say, 10 different liabilities, it feels good to knock off the first couple, and that encourages positive behavior to knock the rest off,” says Ken Mahoney, president and CEO of Mahoney Asset Management.
This strategy is all about reducing the amount of interest you pay on your debts while you work toward a zero balance. With the avalanche method, you pay off your debts with the highest interest rate first.
Let's say you have a Visa account with a $10,000 balance and an interest rate of 17 percent and a MasterCard with a $1,000 balance at an interest rate of only 6.99 percent. Under the avalanche method, you'd focus all your attention first on the bigger Visa balance, because it carries a higher interest rate, rather than quickly knocking out the much lower MasterCard balance with a lower rate.
From a purely mathematical perspective, economists prefer the avalanche method because you will pay less interest on your debt if you eliminate debt with high interest rates, such as the average credit card APR of more than 17 percent. The difficult part, however, is that this payoff strategy takes longer and doesn't deliver the instant gratification that the snowball method does, which increases the chances that you won't see the strategy through. ("You could lose steam and give up long before you even pay off the first debt,” Ramsey notes on his website.)
The avalanche method:
- List your debts (excluding your mortgage) from the highest interest rate to the lowest.
- Make minimum payments on all your debts except the one with the highest interest rate.
- Pay as much as you can on the debt that charges the most interest.
- Repeat until each debt is paid in full.
"The avalanche method is for the person that accepts a slow, long-term process for results and who understands the benefit of … paying less interest over the long run,” says Chrisanna Elser, director of financial planning at Heartland Financial USA and creator of the personal finance blog ThefinU.
But the best way to pay down debt is to use both methods, advises Jamie Cox, managing partner at Harris Financial Group. “I use a combination approach, which starts with the snowball method,” Cox explains. “Paying off a small debt is psychologically more impactful than saving interest in the beginning. Once the behavior is modified, then you can transition to the math” and “move up to the more sophisticated, yet slower, method of attacking higher-interest-rate debt first.”