August 1, 2018 by Nicki Parr, WEV’s Business Recovery Specialist
Last month, we discussed the concept of debt financing and the different types of debt that are available to consumers and businesses. As we find ourselves globally sweltering through the summer of 2018, it is the perfect time to talk snowballs! More specifically, the snowball (and avalanche) methods of debt repayment.
One of the most commonly used (and abused) forms of debt finance is the credit card. In and of itself, it is not necessarily a bad form of debt but its ease of use, its prevalence and the high-pressure sales tactics of many credit card companies can be a heady combination for the undisciplined consumer, or the desperate business owner. Of course, there may be periods in a business or individual’s life where piling on the credit card debt is simply the only way to get through a challenging phase: loans may not be forthcoming, and the savings account may be non-existent. However, it takes real discipline on the part of the consumer to reverse course and get back on track financially after such periods.
Luckily, there are tools available to clearly map out repayment amounts and timelines, allow individuals to regain a sense of control over their finances, and see an end-date when they will be debt-free. Two of the most popular repayment strategies are called the “Debt Snowball” and the “Debt Avalanche”. These strategies can be applied to any kind of debt – credit cards, consumer loans, student loans, etc.
Debt Snowball repayment strategy – in this approach, the consumer specifically targets repaying the debts with the smallest balances owed first, while maintaining minimum payments on the larger balances. This has an important psychological component of seeing the number of debt accounts or credit card bills lessen as the balances get sequentially paid off. However, this approach does not take into account the relative interest rates of each card or debt product so, in the long run, it could cost more than the avalanche approach.
Debt Avalanche repayment strategy – in this approach, the consumer targets repaying the highest interest debts or credit cards first, while paying minimums on other balances. While it may work out to be a more economical strategy, the consumer will not get the earlier satisfaction (and incentive) from seeing debt balances actually paid off from using the snowball method.
Here is an example to help illustrate:
Consumer A has the following debts outstanding:
|Description||Amount||Interest Rate||Minimum due|
|Credit Card A||$4,300||16%||$86|
|Credit Card B||$758||19%||$17|
|Student Loan C||$12,850||7%||$78|
|Consumer Loan D||$1,300||23%||$65|
Consumer A has decided to allocate $400/month to repaying debt. With the “snowball” method, the extra $164/month would be systematically applied to paying off Credit Card B (in 5 months’ time), then Consumer Loan D (in 10 months’ time), then Credit Card A (in 24 months’ time) and finally Student Loan C (in 60 months’ time).
If the “avalanche” method was applied, Consumer Loan D would be paid off first (7 months’ time), then Credit Card B (10 months’ time), Credit Card A (in 24 months’ time) and finally Student Loan C (in 60 months’ time). In this example, the difference in interest rate from applying the strategies is marginal (less than $50), and it very much comes down to personal preference.
There are a variety of free products available online which will model the different repayment strategies. This one is particularly straightforward and easy to understand: https://www.vertex42.com/Calculators/debt-reduction-calculator.html
Like dieting, paying down debt can take discipline and hard-work but with persistence and consistence, you can create new habits that will leave you feeling more in control and financially stronger for the challenges ahead.