Debt Repayment Strategies: Snowball vs. Avalanche – What’s the Best Approach for Canadians?

It’s no secret that managing debt is one of the most commonly faced financial planning issues. In fact, Canada currently has the highest level of household debt to disposable income of any G7 country. Canada’s household Debt-to-income ratio has risen from a healthy 66% in 1980 to over 180% in 2021, meaning Canadians owe $1.80 for every $1 earned – almost twice as high as our southern U.S. neighbours. Whether it’s student loans, credit card balances, personal loans or the biggest one of all, the mortgage, it’s no surprise Canadians are looking for direction with how to approach their household debts. As Financial Planners, helping our clients with an effective strategy to repay debt can be crucial to helping them achieve financial freedom. We often get asked what the most effective way to repay debt is. There are two popularized strategies for debt repayment that we’ve seen be very effective, they are analogously thought of as “The Snowball Method” and “The Avalanche Method”. Today’s blog post will review both strategies to help you make an informed decision on which method will work best for you.

The Snowball Method: A Behavioral Approach

As the name implies, this method can be illustrated by picturing a small snowball rolling down a hill. The snowball starts off very small, and as it grows as it increases in size and momentum. So too can be said of the Snowball Method as a debt repayment strategy. The Snowball Method prioritizes the psychological momentum gained when eliminating a debt. By focusing on paying off your smallest debt first, regardless of the interest rates, the momentum begins to work in your favour. From there, you can move onto repaying the next lowest amount owed with increased cash flow and growing momentum.

Here’s how it works:

1. List Your Debts: Order them from smallest to largest balance.
2. Make Minimum Payments: Continue to make minimum payments on all your debts except the smallest one.
3. Focus on the Smallest Debt: Put any extra money toward the smallest debt until it’s paid off.
4. Move to the Next Debt: Once the smallest debt is eliminated, move on to the next smallest debt, and so on.

Let’s say you have the following debts:

• Credit Card A: $500 balance at 12% interest
• Credit Card B: $2,000 balance at 18% interest
• Personal Loan: $5,000 balance at 8% interest
• Mortgage: $200,000 balance at 5% interest

With the Snowball Method, you would first focus on Credit Card A because it has the smallest balance. Suppose you have an extra $200 a month to put towards debt repayment:

1. Pay $500: Pay off Credit Card A in one month, saving on the interest and eliminating the smallest debt.
2. Move to Credit Card B: Now, apply the $500 you were paying on Credit Card A plus any extra money towards Credit Card B.
3. Move to the Personal Loan: After Credit Card B is paid off, shift all your payments to the Personal Loan.
4. Finally, the Mortgage: Now that you have all other outstanding debt paid off, you can begin to apply more towards principal, subject to pre-payment rules.

Behavioral Perspective: By quickly paying off Credit Card A, you experience a sense of accomplishment and financial control, which can provide motivation to tackle larger debts like a mortgage. This psychological boost can keep you motivated and committed to clearing the next debt, helping you build momentum.

The Avalanche Method: A Mathematical Approach

This strategy is conceptually similar to an avalanche as a small amount of snow falls down the top of the hill and grows in impact as it moves faster and faster downhill. By implementing the Avalanche Method of debt repayment, you prioritize debt repayment based on the interest rates rather than the balances. As you cross-off the most expensive debt, you can free up more cash flow to attack the next highest-interest debt. As your cash flow frees up your momentum builds and the impact on your debt repayment strategy increases in magnitude.

Here’s how it works:

1. List Your Debts: Order them from the highest to the lowest interest rate.
2. Make Minimum Payments: Continue to make minimum payments on all debts except the one with the highest interest rate.
3. Focus on the Highest Interest Debt: Put any extra money toward the debt with the highest interest rate until it’s paid off.
4. Move to the Next Highest Interest Debt: Once the highest interest debt is eliminated, focus on the next highest, and so on.

Using the same debts:

• Credit Card A: $500 balance at 12% interest
• Credit Card B: $2,000 balance at 18% interest
• Personal Loan: $5,000 balance at 8% interest
• Mortgage: $200,000 balance at 5% interest

With the Avalanche Method, you would focus on Credit Card A first because it has the highest interest rate. If you have the same extra $200 a month for debt repayment:

1. Pay Extra on Credit Card B: Direct all extra funds toward Credit Card B while making minimum payments on the other debts. This will reduce the total interest you pay over time.
2. Move to Credit Card A: After Credit Card B is paid off, shift your focus to Credit Card A.
3. Next, the Personal Loan: Once Credit Card B is cleared, apply your payments to the Personal Loan.
4. Finally, the Mortgage: Now that you have all other outstanding debt paid off, you can begin to apply more toward principal, subject to pre-payment rules.

Mathematical Perspective: By targeting Credit Card B, you minimize the total interest paid. The Avalanche Method saves you more money in the long run by reducing the balance on the highest-interest debt first. This method is widely accepted as the mathematically correct approach to debt repayment, however in practice, it may negate the psychological benefits of eliminating that nagging smaller debt first.

Which Method is Right for You?

Behavioral vs. Mathematical

• Snowball Method: This method is best applied to those who would respond positively to motivation and psychological boosts when approaching their financial goals. If you’re the type of person who thrives on small wins and needs that encouragement to stay on track, this method is more suitable for you. 
  
• Avalanche Method: This approach is optimal if your primary concern is to minimize the cost of interest and pay off debt as quickly as possible. It’s suitable if you are disciplined and can stay motivated without frequent rewards.

Final Thoughts

Choosing between the Snowball and Avalanche Methods depends on your personal financial situation and the psychological needs that you most respond to. In practice, it can be complicated when applied to your own situation. For example, let’s say your outstanding mortgage is the debt with the highest interest. If you are a proponent of the Avalanche method, tackling a debt like a mortgage with a high balance can take many years and lots of discipline. Perhaps you’d feel better about your debt situation if you eliminated a lower balance debt in the interim. Ultimately, the best strategy is the one that keeps you motivated and on track to achieving your debt-free lifestyle, and there’s nothing wrong with striking a balance between the two in practice. As always, it’s a good idea to consult with us to tailor a debt repayment plan that fits your specific needs and circumstances. Remember, the most important thing is to start tackling your debt and stay committed to your repayment journey. Happy Debt Smashing!