Debt Snowball vs. Debt Avalanche: Which is the BEST Way to Pay Off Debt?

you've heard of them debt snowball debt avalanche which one works better it's brian preston the money guy brian i'm super excited about this show because i think i think this may be one where we ruffle a few feathers because we're going to share some thoughts and ideas i think they're going to go against the grain of what a lot of folks out there have been taught about the best way to approach getting out of debt getting your debt paid off knocking it out retiring it because i think that maybe our opinion is a little bit different than maybe a popular opinion out there yeah there's a there's a lot of information out there and before we kind of give you the answer because we once again we have loaded this thing up with math because i don't like just giving opinions i want us to kind of go pull out the excel spreadsheet so let's go deep on this thing and let's give it the extra attention that you just don't see in a lot of other places so that's coming up but i first want to kind of set the stage with understanding that america has a debt issue and this is one of those things where guys the sooner you realize you have to figure out are you a builder of wealth are you just a consumer of resources and you use debt to build that bridge to get you where you want kind of before you're actually ready and that by the way when you build that bridge it's dangerous now sometimes right in our financial lives we have to go into debt maybe we're buying our first automobile or making a home purchase and other times it's voluntary we might be buying something at a retailer we might be running up credit card debt either way most of us at some point in our life are going to be faced the decision of what's the best way to get rid of it how do i want to pay it off what's the best mechanism so i think that even though we predominantly talk to financial mutants who don't generally even though america has a debt problem they might not have a debt problem there's probably going to be a season in their life or the life of someone that they interact with where this will be valuable helpful information for you oh no doubt i mean even financial mutants when you're starting out and trying to build your toolbox of knowledge of what to do with your money you could also fall prey so we're trying to help everybody understand have know where money is used how to grow it and how not to fall in the traps and that's one of those big ones to avoid now i think this is a bit of an alarming stat because uh fte daniel pulled this up for us and this is what he found the average american this is from data compiled by northwestern mutual the average american now has 26 621 dollars in personal debt and that excludes the mortgage the average person's walking out walking around out there with 26 almost 27 000 that they owe to someone else for something they've purchased yeah and i think you've said it but i think it's worth repeating excluding mortgages because when you see bigger numbers where you're getting into five digits you're like well anything that's that's not just credit cards it's not just car loans is it you know no this is let's talk about let's get into why this is a problem and part of what i don't like about it is is that you learn very early or at least hopefully if you're watching the money guy content we talk about how easy it is to create financial independence and success with the three components of wealth building which is basically discipline that deferred gratification that creates margin meaning you have to live on less than you make and then you think about from there you actually create money because that's what that margin is it's money so that you can invest the margin the extra and then you hopefully you have enough time to let those assets grow your army of dollar bills the problem is debt works against all three of those because if you're using debt especially for lifestyle that means you didn't create margin that means you actually exceeded what you made you used debt to kind of bridge the gap so you never got to invest the money and you definitely if you didn't get to invest the money you don't have the time to let it grow you might actually be turning compound interest upside down that's exactly right it can be the eighth one of the world that can be wind at your back when it comes to wealth building and building towards financial independence or it can be the headwind that you're going to fight against your entire financial life if you don't get it under control early on so i saw this on twitter brian is you know obviously a friend of the show we communicate back and forth with each other and it is i say something to this effect on the show but i was like when i sit i was like why didn't i create this i mean brian did a really good job because if there is a choice being made do you want to be a builder of assets or do you want to make the banks rich that's the perfect illustration here so choose accordingly and be wise with this now here's the truth of the matter you know in our day job we get to work with successful people all over the country we're fee only financial advisors we work with a lot of millionaire families out there and one thing i think is so interesting is that most millionaires most folks who've been able to build and accumulate wealth don't have debt issues they fall onto the other camp they're not the type that ends up getting themselves behind the eight ball of having compound interest work against them yeah it is it's i think it breaks people have a misconception about that they they come to a financial advisor and expect you to be an expert on bankruptcy to understand how to get out of credit card debt and other things and guys it's just not the fact it's not the way the world works if you're a financial mutant you will come to a point to realize people who are you know going to make good decisions with the money don't struggle with basic discipline matters now look that's not a condemnation on anybody who is strong because we've all been young we've all been without money and resources i'm just telling you don't fall prey and go especially the consumerism with all the ad campaigns all the discussions all the voices with friends and relatives where they act like it's completely okay to be in debt that is not the case if you plan on taking your finances to the next level so okay before we can talk about you know the best ways to get out of debt how to actually satisfy debt let's talk about uh some of the most common types of debt that we see some of the things that americans most often fall in the trap of and the first one that sort of immediately comes to my mind is credit cards yeah right now according to a data compiled by experian and clever the average american with credit card debt at this present moment owns over our owes over five thousand dollars fifty three hundred dollars in credit card debt i wanna make sure i clarify this because this stuff sits out there on youtube or out there wherever you download your podcast this is people who are with credit card debt meaning they're not paying it off monthly but this means that people actually have 5 300 worth of debt and then here's a stat that kind of blew my mind because it's very quickly approaching 50 47 of households carry credit card debt see now one of the money guy tennis we talk about all the time is we have no issue with folks using credit cards we actually encourage that we think it can be a benefit to your financial life but carrying the balance is a no-no it's just something you cannot do i am amazed by the fact that almost half of the population is getting that wrong almost half the population does not pay it off every single month and i think that is uh terrifying first of all and also kind of saddening now here's what's interesting we've come through the pandemic because people couldn't travel spending was kind of cut down and then there's also been all this stimulus money that's been pushed out into the economy a lot of these numbers are actually healthier than they historically have so they've improved from prison because a lot of money's been put in the system i think this is a good point if you have struggled with credit card debt but you've gotten the stimulus money you've also been able to kind of reset your own personal consumption because you haven't been able to do stuff let this be the ground zero to kind of set yourself up for success going forward because this could be a positive moment here and then the second type of debt that we often see uh are is consumer credit like you go to the local big box retailer local electronics store and you buy something you have a credit card specifically with that retailer yeah and the way these things typically happen i mean i don't care if you go to kohl's um your favorite electronic store nordstrom i mean it doesn't even have to it can be your coffee shop these days i mean you just go mobile app is going to be pushing this everybody's trying to sell their corporate card and they'll usually they'll give you some type of incentive if it's at a furniture store they'll offer your 10 percent off you know they'll give you bonus points if it's through your coffee app all these things have this incentive and you might be caught in a moment of weakness and think that the discount is worth you opening another credit card guys i'm going to er or store credit i will tell you be very careful with this i have my own experience shares on this is that that 10 sometimes is not worth it if you're not communicating with the other people in your household because there's discounts it sounds like you're saying that from perfect space yeah we've we've had credit card you know a store credit that was opened earlier in our marriage that resulted in some late fees and interest and other things and then also i can tell you from a knucklehead mistake i made i went because i was so excited with my first house purchase that we bought furniture and when they you know and it's a few thousand dollars worth of furniture so when they offer me 10 i'm like that's real money i'm like that's a few hundred dollars i could save right there not realizing since i had not closed on the house yet that ding to the credit it did have an impact on my credit score so be very careful on how many different credit accounts including store cards that you're opening up out there no don't mishear us we're not suggesting oh don't ever have a store card if there are stores that you frequently shop at and that you use then the benefits make sense for your situation that's okay you should still pay them off every month we're not saying don't use them at all what we're saying is you want to be careful of opening one up at every store you go to to try to accumulate the discounts when in reality those discounts may cost you more over the long term than you realize i want you to be very deliberate with how you use your credit i mean there's a reason look we have in the background a credit score that is running on you at all times there's also look there's crooks that try to use your credit there's so we we recommend i actually like the thought of freezing your credit through the three credit bureaus because that also makes you much more deliberate with any time you want to open a new credit line you have to go unfreeze your credit from those credit bureaus man that makes you talk about measuring twice cutting once i like that extra layer by the way it's instantaneous so it's not a big deal but it does allow you to be a little more deliberate and take the emotionality out of the entire process a third type of non-mortgage debt that we often see folks get themselves in trouble with our auto loans yeah we all love the big shiny new automobile it's something that everyone can see there are safety features there's new technology but what i thought was really alarming is when daniel was pulling these stats we found that the average auto loan term for new vehicles right now is 72 months i think that's just absolutely insane because i know a lot of folks don't even drive cars for that long so it's incre insane the people are borrowing for a longer period of time than they actually even own the automobile i think the stats are even worse than this because when i was i was like oh this 72 months people aren't they realize you divide that by 72 by 12. i mean we're talking about six years here and i just you know when you want to have the optimistic goal of your driving your car is at least a decade you're going ahead and locking yourself in when you do this type of debt we know that's not even the behavior of the typical consumer but i think it's even worse only 26 of new car loans are for five years or less and so that just does that flies in the face of all kinds of advice that we give you because even five years i think is realistically probably too long to try too long to try to finance an audible and here's why let's give you a clue on this on why auto loans are disasters um cars depreciate i mean the the moment you buy a vehicle it depreciates really quickly to the point that you really you know if you are optimizing your cash flow situations you typically don't want to buy a car until it's used for three or four years so somebody else is paying that 40 to 50 percent of the depreciation out there so you do not these are not appreciating assets unless we're talking about like a 1967 camaro or something everybody always throws out those antique cars as the exception to the rule but are you really financing that for somebody everybody's doing that so i'm just telling you be very careful with with credit card i mean with cars because and that's why we put the guidance of 23 8 it's something that you really ought to be aware of so you don't get yourself in that type of situation and one way that we know folks aren't subscribing to 23.8 where you put 20 down and you don't finance for any longer than three years and you don't let your car payment exceed more than eight percent of your monthly gross income we know that people are falling short on that because the average amount finance for new car purchases in this country right now is 35 228 you can look at the average income for the average american in this country you can see we are way off from 23 8 affordability and you know we've done so many shows on net worth by age or 401k savings by age how many 20 and 30 somethings don't even have 35 000 in their investment accounts but yet they have a loan for 35 000 that's working against them that's why we we do add on top of 23.8 if your car payment is less than your i mean is more than your investments you're doing it all wrong you always want your investment cash flow what's going out for your your future self to be better and greater than what you're spending on your depreciating asset and then sort of the last uh non-mortgage debt that we feel like is super super commonplace these days are ones that i think a lot of folks thought they can't avoid right i have to do this this is something it's not even really debt it's a it's an investment in my future well-being and of course we're talking about student loans yeah and student loans they still get classified you know what's called loosely good debt you know mortgages student loans these things are considered good debt in the fact that you're investing in something that's either appreciating or it's going to make you a better version of yourself but i think there ought to be an asterisk next to that because you know watching some of the documentaries and other things on student loan debts we do have a crisis in a lot of ways is because we've expanded how many majors there are out there we've increased the cost of education tremendously and then the way that that has all been bridged is they just let young people and parents just sign off and take on more debt yep and and that seems like a simple solution especially when you say good debt because you think what could go wrong with this what can go wrong is when you take on more debt than economically feasible for you to pay off and that happens when you have jobs that their first year starting salary is not even even 10 years in the future your salary was not going to come close to covering the six figures of student loan debt that you built up over the years so we've actually created some guidelines on this here's what we'd recommend don't take on more student loan debt than what your first year salary will be right out of college yeah that's that's such a great piece of advice because we know that the class of 2019 graduated with an average of twenty nine thousand nine hundred dollars a student loan debt and that's the average that means that half of the folks that graduated had more than that had a larger amount than that we all know when we first come out of out of our career or out of college and start our careers we don't always start at the top of the pay scale so if you already start and you're 30 40 50 000 in debt it's going to take you years upon years upon years just to get back to break even so if there are ways that you can contain that you can keep that number down you certainly want to do that so you can get to actually building wealth a lot sooner well we know that highly of the habits of highly effective people begin with the end in mind i would encourage you if your grandparent parent or your student yourself think about what you actually want to do for a living go look at the the majors that actually generate the highest incomes and also pay back student loan debt the easiest i mean i would look at that and then also go look at how powerful it is to consider doing community college your first two years um in some states that's actually even highly subsidized because the only only name that goes on the diploma is the one that you ended at right it doesn't say oh well i got a degree from university of georgia but first two years when community college it doesn't do that you just want to make sure that the last the place you graduate from has the name on there it might not be worth paying the exorbitant price tag for those early core curriculum classes well that's why i would have a 360 approach meaning you're looking at the big picture all the way around when you're comparing whether it's community college state schools trade schools or then the private schools just make sure like i said begin with the end in mind so that you don't go to some expensive private school but you end up with a salary that just is not going to be economically feasible for what you're trying to do just be very aware of that because i think that that is something that people fall in a big trap on because good debt can be bad for your financial life if you don't do it properly all right so we've covered sort of the different types of debt that you might have or that you might come into contact with now let's talk about some strategies for paying off debt and really when we're talking about strategies there are sort of two main strategies we want to focus on the first is the debt snowball and the second is the debt avalanche you may have heard of these or not heard of these so whenever we introduce new vocabulary we like to do definitions for you so when we talk about a debt snowball it's simply when you pay off your debts in order of the smallest to largest so whichever one of your balances is the lowest you want to pay that one off and i think brian the general idea behind this one is it is behavioral it wants people to get excited about about satisfying that debt so that they keep going it gives some some little early wins early on we know keeping habits is hard i mean especially when you're starting out you've got a past of bad behavior now you're trying to transition to good behavior i think the methodology or the reason on why on this makes complete sense because there are some people that are so broken in the way they've processed their financial decision making that getting some wins early and often can probably keep them on the track a success but that doesn't mean that's the best for everyone i think that's what's always very important when you're talking about where you get your information from is make sure that the information reflects who you are and how you process the financial world because this is great for people who have who are dead aholics who who cannot keep themselves straight who can't get out of their own way but if you're more of the financial mutant status there could be an alternative for you yeah the second method of debt payment is known as the debt avalanche and this is quite simply where you allocate any extra repayment of funds to the debt with the highest interest rates so you don't really care about the size of the balances you care about the interest rates and you want to pay off the highest interest rates first all the way down to the lowest interest rate so what that does that allows your marginal cost of each dollar to be as impactful as possible when you're satisfying that debt yeah so this is math optimization is what this is when you're doing the avalanche it means we're looking we're listing all of our debts and we're saying which one of these suckers is really sidelining my my growth because i'm paying a much higher interest rate than all the others the problem i think and this is where the behavioral people go back to the snowball is that what happens if that's one of your your debts that's a little bigger in sizing you don't get that quick behavioral boost so it does fall into it's counting on you to be good at math be disciplined and want to pay off those high interest debts first so so then the next question is which is better the avalanche or the snowball how do you decide which one makes the most sense for and you kind of said it's very much an individual behavioral decision and then does it even matter does it even make a difference or are they both good and you'll be in the same spot no matter which way you go wait a minute i smell it i see a case study coming our way and i bet daniel has some great clip art because he gets so excited showing us his different clip art that he's put together let's look at what daniel's created so we can kind of look at the details of the math of this so this is what we want to put together we're going to look at two different debtors and daniel has called this a tale of two debtors we've got snowball sam who's going to do the debt snowball and we have avalanche abigail i love his naming what you don't know is abigail had a cane the first time i saw this and i was like why does abigail have a candy cause oh let me see if i can mix this up well good i'm glad he took her cane away and gave her a book so obviously sam is going to follow the snowball method and he's going to prioritize the smallest debts first he's going to look at the smallest balances and knock those out first abigail is going to pay off the debt with the highest interest rate first so let's assume they both have the same debt so let's assume that their debts are five thousand dollars from a local retailer and the current interest rate on that is about 1.9 that sounds like a teaser rate that's a teaser rate is what it sounds like uh let's assume that their second is a six thousand dollar uh debt on a credit card oh but this one is at nineteen point nine nine percent which is pretty uh pretty scary when you think about how how high that interest rate is and then have a third credit card where they owe 7 500 but this one's actually at 29.99 now here's what i think is interesting and i know you'll you'll we'll come back to it i didn't believe that there's actually 29.9 percent but i'll let you prove me wrong in a minute and so let's say that they have a 200 extra per month that they can put towards paying to debt you know uh snowball sam is going to do the snowball and abigail avalanche is going to the avalanche and we're going to see how they differ how it comes out now you did ask the question brian well 29 i didn't believe it average apr is somewhere between 17 and 18 29 doesn't really exist that's what you were saying pre-show i was like i mean think about this i mean guys every dollar you save and work i i get excited about and you guys troll me when i talk about 20 somethings could potentially get nine to ten percent compounded growth you guys are like where is that i've never seen that meanwhile if i know there's a whole section of the population out there is paying 30 per year to a credit card they're having i mean we're leveraging out how much opportunity is being squandered here with high interest rates so so daniel had to go show me yes this does indeed exist yeah so we actually went out and found two credit cards that currently have aprs of 29.99 it also looks like they have monthly fees after the first year so these are just not the ideal credit cards that you want to get but you know what the good news is you get cash back one to three percent cash back but these actually do exist out there so one of the things you really want to check on is maybe the the card that you're utilizing early on if it does have an annual fee or it has a higher interest rate or there are other benefits it doesn't have and maybe you've had it for the last three four five six years now might not be a horrible time to revisit that theoretically you should not care a ton about the interest rate because remember you're not going to carry a balance but it's not uncommon for you to have better access to better credit cards later in life on your financial journey i also want to draw attention this is something i don't like that the financial industry does the worse you are with the money with your money the more they're going to penalize you exactly so because the only people that would be willing to pay a monthly fee on a credit card and then pay a 29.9 or obviously people who have struggled with good decision-making with their personal finances so this is going to just pile on top you're going to layer instead of good things happening for you financially it's the army of dollar bills and compounding interest is actually against you so you need to quickly realize this is all going to come down to how do you want to be viewed by the banks and others do you want to be a partner that they're trying to throw things your way so you can be successful win with low interest rates low insurance rates and other things or do you want to be that pres you know where they pray upon you they've got that predatory lending where they jack up your rates they charge you all kind of fees be mindful start trying to figure out how do we build the deferred gratification how do we get the discipline to live unless we make so we never get in this type of situation so let's take a look and see how sam and abigail did remember they're both going to pay 200 a month towards satisfying their debt sam who went with a snowball approach would have ended up paying 29 806 dollars in total paying off all the debt plus all the interest that accrued and it would have taken him about 5.6 years to get that paid off now abigail on the other hand who went with the avalanche method paying the highest interest rate first and working her way to lowest well she would have actually only paid 25 223 in total debt payment and interest and she would have had it paid off in 4.7 years almost a full year earlier than sam so here's what i think is also interesting on this remember the setup is the they're paying the minimum plus the 200 and they have the same debts so incrementally these are the same dollars going in it's not like we ignored one concept on another this is incrementally one dollar is the same as this dollar it's just how did they actually allocate the money and i'm just shocked because if you look at this and there's a reason abigail is basically doing a dance move she's dancing it's because she gained a year that she actually was not under the you know the thumb of the debtors and then she also gained about two-thirds of what a roth ira contribution could be so those two things together man it is powerful to understand where you are from a behavioral standpoint so that you know hey look i don't have to do this just to get the kudos i'm going to do this because i'm good at math and i want to minimize the interest i'm paying now get remember neither one of these are ideal because we really don't want to be in debt if we can avoid it but it is interesting we look at the breakdown by account on the retailer remember they had a total balance of five thousand dollars well abigail did pay more on that debt she paid 219 dollars in interest where sam only paid 71 and actually uh abigail paid more on the middle credit card as well she paid almost 3 300 in interest on that one where sam only paid 2 400. so if you kind of stop the illustration there you say man sam paid a lot less interest than abigail because you know those two he was significantly lower however it's because that high interest rate on that large balance just kept gobbling and gobbling and gobbling and gobbling up interest for sam where he paid way more interest over the life of these debts than abigail did i mean having that 29.9 credit card is like having termites in your financial household because you didn't see the damage it's going on the silence but it's munching away at your opportunity in future and that's why i do think that this is if you are the type of person that has high high interest rates guys try to get on the discipline train to maximize getting those high interest debts paid off as soon as possible now we didn't show it here but the real exciting thing is you said this brian abigail saved almost what should be able to max out her roth ira with think about how powerful those dollars what she was going to do she could go to moneyguy.com resources and go see man if i took that four thousand five hundred eighty three dollars of interest and i invested it today eleven months sooner than sam did what could that turn into by the time i retire and it gets powerful while that might not seem like a huge amount of money early on that forty six hundred dollars can be huge when you take it out 20 30 even 40 years into the future yeah so i want to talk about what's the actionable steps here how do people need to think about this first of all do you have credit card debt that you're not paying off monthly if that's the case i do think you have to go to extreme measures i don't care if that means you know there's back i'm from atlanta there's a a total consumer advocate that would literally advocate putting your credit cards in a glass of water a cup of water water you could i guess you could say red solo cup or something putting water in it throw it in your freezer so you're literally freezing physically your credit card so you don't have access to it so then you turn this into how do we get out of debt since you're not swiping anymore i think that that's the big thing you've got to stop digging because credit card debt is not a shovel it is the biggest excavator of moving earth that you've ever seen especially credit card debt like i said 30 interest there's no way you recover from that if you don't knock it out as fast as humanly possible and that's the part you have to figure out do you need to celebrate small wins if you do maybe the debt snowball does work for you but it probably does mean you're you're paying extra interest whereas if you're a financial mutant your person recognizes i am changing my life i am building for a better tomorrow for myself that great big beautiful tomorrow by using deferred gratification today you probably will like the dead avalanche method if you need some motivation go out to the website moneyguy.com resources click on our deliverable how powerful are your dollars and it will show you how much every dollar can be doing for you if it's in your army of dollar bills instead of working against you in debt debt should be a four letter word it's okay to use it it's okay to have a store retailer it's okay to have a credit card it's okay to have an auto loan but you want to make sure if you are utilizing those tools you're using them well and you're using responsibly so that they can be tools for your wealth building journey not tools to dig yourself into a hole that you can't get out of well i never know who's watching our videos and in my mind i like to think based upon the emails and the comments you guys post some of you are brand new to personal financing you are starting to recognize internally maybe you are mutating a little bit and you want to do things better but you don't come from a household because i've you know the stat i'm going to say 80 percent of millionaires are first generation meaning their parents weren't millionaires so you might not know how to optimize what to do with your next dollar and it's not like there's a lot of resources out there that say do this with your next dollar we've actually created it if you go to moneyguy.com resources we do have the nine steps of the financial order of operations money is no different than math you will get math wrong over and over again if you don't understand you know please excuse my dear aunt sally i mean because that's the thing you have to know do you do addition first you do multiplication do you do the parentheses you've got to know the direct order money is the same way so make sure you understand the financial order of operations we've laid it all out for you and we want to give you we want to accelerate your process in creating success now here's what happens we hope that you'll show up we hope that you will learn these concepts that we are sharing with you hope that you'll apply it to your financial situation and once you do get out of the debt we hope you'll continue to grow we'll hope that your financial empire will continue to build and when you get to the point where maybe you don't have enough time to keep an eye on your finances or maybe the gravity of your financial decisions is just too great you don't want to go at it alone or maybe you just don't know what you don't know you'll remember the team that planted those seeds and helped start you on the abundant cycle of building towards financial independence yeah i think that's a great invitation because look we don't ask for anything in return it might be years in the future that you actually reach that abundant cycle moment but we're gonna be here we're gonna keep creating free great content for you guys keep it investing in you and we're just so thankful for all that you provided us so we can keep loving on you and creating more and more success i'm your host brian preston mr bo hansen money guy team out

Channel: The Money Guy Show

Views: 17,108

Rating: 4.9168401 out of 5

Keywords: money guy show, debt, budget, cash, real estate, insurance, how to make money, save, credit card, compound interest, buying house, buy stock, success, personal finance, Debt Snowball vs. Debt Avalanche: Which is the BEST Way to Pay Off Debt?

Id: lYKAwumnVm4

Length: 33min 21sec (2001 seconds)

Published: Fri Jun 11 2021