in debt? How the ‘avalanche’ and ‘snowball’ methods of paying off debt work

Mortgage, automobile, home appliances and credit cards. Debts accumulate and, without knowing how, we are left with the rope around our neck. This is happening to more and more people all over the world.

Global private debt rose by 13% of global GDP (Gross Domestic Product) in 2020, the biggest increase in two decades, the International Monetary Fund (IMF) said this month.

In some Latin American countries, the majority of the population owes money to financial institutions, as is the case in Peru, where more than seven in 10 people said they were in debt in a recent survey by the consultancy Datum.

And in the United States, credit card debt hit a record $890 billion this month after growing by $100 billion in a single year, according to the Fed.

When payment commitments accumulate, many debtors adopt strategies to meet their obligations as intelligently as possible.

Two of the methods most recommended by experts are known as “avalanche” and “snowball”.

We explain below what they consist of.

the avalanche

If you are a balanced, patient and calculating person, your strategy is the avalanche. First, you should make a list of all your debts and order them from highest to lowest interest rate. Your goal is to pay the minimum required of all of them.

And for the one with the most interest, dedicate all the extra money you can each month until you pay it off.

For example, if your mortgage is 8%, the TV you bought is 12%, your car is 15%, and your credit card debt is 25%, contribute all your funds. as possible to settle the latter, always complying with the minimum payments of the others.

Once you’ve cleared your credit card balance, use your extra budget each month to cover the car payment, then the television, and finally the mortgage.

The effectiveness of the avalanche is in the interest rates, which in most loans represent a significant part of the monthly payments.

The higher the rate, the greater the amount of money that is devoted to covering interest costs and the less corresponds to the capital or value of the product itself.

With this method, you will save money by preventing accounts with the highest interest rates from continuing to add to your debt indefinitely. Mathematics doesn’t lie.

the snowball

But math is not everything. A debt situation can cause high levels of stress, so psychology is a factor to consider.

Seeing debt building up over time can be demotivating and hamper your efforts to reach your desired zero balance.

Take the case above: you have a mortgage for $100,000 (about R$515,000), you just bought the TV for $1,000 (about R$5,500,000), you have $5,000 (about R$5,000). 25.8 thousand) in his car and owes US$ 10 thousand (about R$ 51.6 thousand) in credit cards.

If your first goal is to pay off credit card debt, but your income is tight, it can take years to achieve that, and without tough discipline, you could throw in the towel halfway through.
Then you can go for the snowball strategy.

First, make a list of your debts as in the previous case, but don’t order them by interest rate, but by value.

Sure, make the minimum payments for all, but dedicate all the extra money you can to cover the lower one until you pay.

In this case, you should do your best to pay for the TV first. An achievable goal, right?

Upon reaching the first goal, you would soon see the results of your efforts, which would further motivate you to continue paying for your car, credit card, and mortgage, in that order.

Although from a purely mathematical point of view, the snowball is less efficient than the avalanche, according to experts it can achieve the same or better results.

There is also the possibility of combining the two methods: first pay the smallest debt and, with the motivation of the first success, move on to the avalanche strategy to face the rest of your debts.

It is essential to manage your debts well

For the Mexican academic and financial expert Norman J. Wolf, both strategies can be valid, as long as there is stable income.

And, if you have accumulated a very high amount, “another reasonable option is to consolidate the debt with a single bank”, he says.

Wolf, who is a professor at the National Autonomous University of Mexico, offers some advice for managing your debts in the smartest way possible.

“The first step is to know what we are hiring when we buy something. It is necessary to look at the amortization table and, if you don’t understand, ask a specialist for guidance.”

This table shows all payments to be made on the loan, such as how much principal and interest must be paid and what is the outstanding debt in each period.

“In the long run, what we’re looking for first is paying off the principal: being able to make big payments that pay off the balance that’s due and so the interest goes down,” says Wolf.

The specialist guarantees that, in an inflationary moment like the current one, it is best to “give priority to those amortizations in which more capital is paid first and interest is left over at the end”, data that must be included in the amortization table.

And, in case he has to choose between snowball or avalanche, he leans more towards the latter.
“You can see what the most aggressive interest rate is, and I would say, pay off the debt with the highest rate first and then pay the debt with the lowest rate.”

This text was originally published here.