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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