Debt Snowball vs. The High Interest Approach

I’ve been looking for a good real-world example to compare the traditional “debt snowball” approach to the approach of paying off the high-interest loan first above all. Today, I received a note from a reader named Bryan:

I just graduated college this year, and am starting job where I’ll make $47,000. I’ve got significant student debt, which I will try to pay off as much as I can the next couple years (while my responsibilities are minimal).

My question is this:

I have 3 loans:
- $5000 @ 3.75%
- $11000 @ 6%
- $40000 @ 8%

Which one do I focus on paying off first?

It seems like the largest one with the high interest. But I could “snowball” it, and pay off the smaller ones (while paying minimum on the large one), and then use that money to hit the large one hard after the small ones are paid off.

What are your thoughts?

In order to see what the minimum payments would be on each loan, I headed over to Bankrate.com’s amortization calculator. I assumed that each debt was for ten years, so given that assumption, here are Bryan’s minimum payments:

The $5,000 debt has a minimum payment of $50.03 per month.
The $11,000 debt has a minimum payment of $122.12 per month.
The $40,000 debt has a minimum payment of $485.31 per month.

These debts total up to $657.46 a month.

Let’s also assume Bryan is going to devote 25% of his pre-tax salary to taking care of this debt, $11,750 a year, or $979.17 a month.

The Debt Snowball Method

Using the traditional debt snowball method, Bryan would focus on paying off the smallest debt first while just making minimum payments on the rest.

The first debt Bryan takes the $321.71 extra each month and applies it to the smallest debt. He would have this first debt paid off in fourteen months.

The second debt At the fourteen month mark, Bryan takes the extra $371.74 each month and applies it to the $11,000 debt, which because he’s been making the minimum payments, now has only $10,029.12 to be repaid. He would have this second debt paid off at the thirty six month mark.

The third debt At the thirty six month mark, Bryan takes the extra $493.86 each month and applies it to the $40,000 debt, which because he’s been making the minimum payments, now has only $31,137.16 to be repaid. He would have this third debt paid off at the seventy two month mark.

The “Highest Interest” Method

Using the highest interest method, Bryan would focus on paying off the highest interest debt first while just making minimum payments on the rest.

The first debt Bryan takes the $321.71 extra each month and applies it to the highest interest debt, the $40,000 debt. He would have this first debt paid off in sixty one months.

The second debt At the sixty one month mark, Bryan takes the extra $807.02 each month and applies it to the next highest interest debt, the $11,000 debt, which because he’s been making the minimum payments has only $6,226.32 to be repaid. He would have this second debt paid off at the sixty eight month mark.

The third debt At the sixty eight month mark, Bryan takes the extra $929.14 each month and applies it to the remaining debt, which because he’s been making the minimum payments has only $2,397.76 remaining to be paid. He would have this final debt paid off at the seventy one month mark.

Which Method Wins?

The “highest interest” method obviously gets the debts paid quicker, which means that Bryan would pay less in overall interest by going that route. However, with that method, the “successes” don’t start happening for more than five years. With the debt snowball method, the successes occur more regularly through the process, meaning it’s better for keeping your encouragement up as you repay.

For me, I would still go with the “highest interest” method – it simply puts more cash in your pocket in the end. I would also advise Bryan to never make more than the minimum payment on that 3.75% debt, because he’s cash ahead by even putting money in a high-yield savings account than making early payments on that one.

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  1. amanda says:

    Student loans are NOT 10 year loans. From that assumption, I would make a further assumption that you are not in student loan debt hell yourself! They are probably 20 year loans so the minimum payments are probably about half of what you calculated.
    There is a huge amount of difference between 8% and 3.75% so in this case, I think you’ve got to attack the 8% loan first.

  2. Jon says:

    All depends on the loan. Some “student” loans can be 10 year loans. Yes maybe all student loans are not 10 years, but neither are all 20 year loans. I had the opportunity to lock my student loans in at 10, 20, or 30 years when I consolidated. All depends on who is lending you the money.

  3. Duane Gran says:

    An additional point is that student loan payments are tax deductible if you are below a certain income threshold (65k, I believe). This gives added motivation to pay the other notes first.

  4. frank says:

    One way to see the “success” as you call it is to calculate the weighted average interest rate to see that decrease over time. That’s what paying down the high interest debt is all about.

  5. shawn says:

    I would also advise Bryan to never make more than the minimum payment on that 3.75% debt, because he’s cash ahead by even putting money in a high-yield savings account than making early payments on that one.

    Yeah, except for a little thing called income tax. After taxes he’ll either be behind or barely ahead. Even if the interest on the loan were tax-deductible you’re talking about a spread of at best about 1.5% (and more likely about 1.25). That’s peanuts and not worth the headache of keeping the debt around. Nobody is getting rich or even building wealth off of 1%.

    Furthermore you neglected to mention that you’re talking about a ~1% difference in total outlay whether you go with the debt snowball or the highest interest method.

  6. Rick says:

    Amanda, that’s a pretty brazen statement, one that’s also wrong. All my student loans have been 10-year loans.

  7. GHoosdum says:

    @Duane:

    Student loan INTEREST payments are tax deductible, not the full payment. This is deductible even for those that take the standard decudtion, itemizing is not necessary for this.

  8. Special Ed says:

    I don’t know if these loans are 10 or 20 year loans, but I have to agree with shawn. Paying the minimum on a 3.5% loan isn’t much of an advantage once you figure in taxes on a high interest savings account. You could easily lose money depending on the rate of return. I would suggest that if we are looking at a 10 year loan, you should pay the minimum and look at investing in a Roth IRA. A no-load, low-cost index fund would also be a good option for the long term. This should easily surpass anything a savings account will pay you.

  9. Ed says:

    Dave Ramsey usually states that personal finance is 90% behavior and only 10% about the math. Meaning, as you point out, the small wins along the way keeps the snowball going. If your so good at math, how come you have all that debt to begin with? If being smart in math did not keep you out of debt, how is it going to help now?

  10. amanda says:

    Sorry. I graduated in 2005 and none of the loans I was offered (federal or private) were 10 year loans. I’ve also consolidated loans (in 2006) and was never offered a 10 year loan. I thought I was right…

  11. Mitch says:

    My understanding is that the repayment time for the Perkins is 10 years. Repayment for the Stafford is 10 to 25, depending on amount borrowed and which repayment plan you choose (there are short- and long-term standard options, plus one that increases and one that is income-sensitive). These are the two main US programs for undergraduates.

    If you had below-average loans, you probably only saw 10-year loans, but if you had a loan-heavy year, then you might be talking about longer terms. As for consolidation, that is a whole other ballgame.

  12. Grant says:

    It’s obvious that you should pay off the highest interest loan first. I recently asked my girlfriend how she was doing on paying off her credit cards and she said she just realized that she’d be better off paying the minimum on the card with the 5% interest rate and put the rest towards the one with the 14% interest rate. Duh! I swear I asked her about 2 years ago to make sure she was doing just that and she said she was.

  13. Robert says:

    Lets look at a different senerio:

    Three and a half years into paying off these debts, something happens and the writer has to use his emergency fund.

    Lowest first: The writer has an extra $493.86 that he can use to rebuild his emergency fund. A $1000 would only take 2 months to rebuild. Also, if the emergency were big enough to take out a short term loan to cover, that extra money could pay off that small loan very quickly.

    Highest rate first: The writer has 321.71 to rebuild that emergency fund. It takes a little over 3 months to again reach 1000 dollars. A small loan could still be quickly paid off, but not as quick.
    __________________________________

    Paying off the smaller loans first costs you $900 over 5 years. But it not only gives you some psychological victories along the way, it gives you a little more cushion should a big emergency arise.

    I would almost always be in favor of paying off the smaller loan first. Even in this extreme example, it costs very little to pay off the smaller loans first.

  14. Debbie says:

    I was surprised there’s only a one-month difference. So I did my own (probably less trustworthy) math and got almost the same results (a two-month difference).

    So the most exciting result for this example is that adding that extra money the whole time changes it from a ten-year debt to a six-year debt, either way you go. Paying off extra money to any of the debts is much more important than which debt he’s paying it to.

    So maybe other issues are more important. For example, with the snowball method, he has one or two loans most of the time and with the high-interest-first method, he has three loans most of the time. That means he’s got more opportunities to forget to make the payment on time, to run out of stamps, to keep the automated payments going properly, etc. If this is ever an issue, or if one of the smaller loans is from a company that causes headaches, it’s worth looking into debt snowball.

    If he gets a psychological thrill from having some of the loans paid off, he should go with the debt snowball.

    I don’t know which looks better on your credit record: having some loans paid off, or having more long-standing loans with perfect payment records?

    Another thing to keep in mind is that he says “pay off as much as I can the next couple years.” If after two years he switches to paying only the minimum on everything, then with the debt snowball method, he’ll be paying for the two most expensive loans ($607.43 total) until about month #73, then $485.31 for the rest of the ten years. With the highest-interest-first method, he’d be paying on all three loans ($657.46) until about month #90, and then just paying on the two smaller loans ($172.15) for the rest of the ten years.

    If he’s thinking of switching to paying only minimums later, I’d split the extra across all of them now so that they could all be paid off in less than ten years.

  15. cami says:

    @ GHoosdum: the phase-out for student loan interest deductions starts pretty low (a few years ago it was around 50k), so there’s a chance that in a few years he might be able to reap the benefits of the interest deduction for very long (if you gets raises or bonuses along the way).

    The 40k loan @ 8% is likely at least a 20 year loan. Personally I would probably start with the 8 % loan and then funnel any additional funds (raises, “third-paychecks”, etc.) at the 3.75% loan.

  16. GHoosdum says:

    $50K is still where the interest deduction begins to phase out. Furthermore, only up to $2500 in annual interest is deductible.

    Regardless, my point was that it is only the interest, not the full P&I payment, that is deductible.

  17. Stephanie says:

    Currently, I’m paying extra on my high interest (~8%) student loan, and just letting the bank automatically deduct my minimum payment for my lower interest (~4%) loan. I make sure to pay extra towards the principal…because at least from what I’ve heard,you only pay interest on the principal for student loans, not the whole amount (unlike how you earn interest in a savings, which is on the principal plus the interest). I could be wrong about that, and hopefully someone can direct me about that.

  18. Amber Yount says:

    Hmmm but they still get paid off at the same time…and if student loan interest is tax deductible…wouldnt it then make sense to pay of the smaller ones first? or perhaps he should just consolidate?

  19. Mardee says:

    My student loan debt, about $80,000, is a 30 year loan. Once it gets to a certain amount, the life of the loan increases.

    By the way, there’s another method of paying off debts – I read it in “Life or Debt” by Stacy Johnson. First you create a table or spreadsheet and list the current balance on all the debts. In the next column, put the minimum payment due each month. In the 3rd column, divide the current balance by the minimum payment. The lowest number goes to the highest place on the list, and is paid off first.

    The idea is to focus on the debt with the fewest monthly payments left, according to the author, which means that it will be gone the quickest and the debtor will see the fastest results that way. I haven’t tested it but it sounds like an interesting theory.

  20. Elaine says:

    Whew. I just plugged in all my numbers. It’s not pretty, but there are no decisions to make. My lowest balance has the highest interest rate, second lowest balance has the next highest rate, and the highest balance card has the lowest rate! 1-2-3!

    Why can’t life work out this simply all the time?

  21. reulte says:

    Are they all school loans? Or loans of various types? All other things being equal, school loans should be paid off last not just because the interest is tax deductible, but because is is becoming common for certain business/agencies to repay back school loans for their employees as both hiring and retaining incentives. For instance, three years ago my agency started paying school loans for employees meeting certain conditions . . . the government will repay some loans of teachers who work in certain areas.

    And there is no money like free money.

  22. Danielle says:

    I have Microsoft Money (the software came free on my computer) and use that to keep track of all my accounts.

    Each month, I pay extra on my car loan (my only outstanding debt) and then pull up my new amortization schedule which Money automatically calculates for me. Seeing how paying an extra 85% of a payment now knocks off an entire payment plus a little extra is motivation for me.

    I’m not sure if there is an easy way to do this in excel. But I know for me, getting to see how the extra payment now multiplies when I’m saving 8% interest on a loan that’s at least a decade long would be highly motivating. Even if I still had two smaller loans at lower interest.

    The other thing Money does is when I put in a payment on my loan, it calculates how much is going to interest. Seeing the interest drop each month (as the balance on the loan gets lower) also brings me joy.

  23. jd says:

    Go for the smallest amount first. It’s worth the peace of mind to see you’re really making progress.

  24. Beth says:

    If this were me, I’d pay off the smaller one, than go for the highest rate. Why? Because after a year, I’m down to making two payments, rather than three. I understand the math of paying the highest interest one first, but I’d feel better paying two bills rather than three. It has nothing to do with the psychology of thinking I owe more, it’s just the annoyance of writing three checks and sending in three bills rather than one. I’m lazy and absent-minded. Anything to lessen the chance of missing a payment!

  25. Tim says:

    the only missing factor is if any of the debts are variable interest. If so, that would make things more interesting. Personally, i’d go after the small one first, then split 1/3 and 2/3 towards the other two, with the 2/3 of small debt payment going to the $40k.

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