Buy now, pay later.
That’s how the vast majority of Canadians are handling their day-to-day spending. Credit cards account for $100 billion of outstanding debt in Canada and it touches almost everyone. You have to pay it off if you want a higher credit score or relief from financial anxiety, but how do you do it? There are two popular methods to pay off debt: the Snowball Method and the Avalanche Method. Do you know which one is right for you?
The Snowball Method to Eliminate Debts
The Snowball Method is a debt repayment strategy popularized by personal finance guru, Dave Ramsey. In this method of paying down debt, you make all your minimum payments to all your debts. But you put as much extra money onto your debt with the lowest balance owing first.
Once you’ve paid it off, you take the extra money you were putting onto that debt and add it to the next lowest debt balance owing. Once that debt is paid off, you repeat the process – moving up the list from lowest balances owing to the highest.
It’s easier and faster to see results when you pay off the smallest balance first. That’s what makes the Snowball Method so effective. There’s a powerful psychological effect when you see your hard work pay off in a relatively short period of time.
According to Harvard, the Snowball Method helps more people pay off their total debt than any other method. So why do it any other way when this one works so well?
From a purely numbers perspective, it’s not very cost effective. While you may be super motivated to keep going and eventually pay off all your debt, the Snowball method is likely to cost you more interest over the long term depending on the type of debt you have and how high the rates are.
The Avalanche Method to Eliminate Debts
Just like the Snowball method, you make all your minimum payments. But instead of putting your extra money onto the debt with the lowest balance, you put as much extra money as possible onto your debt with the highest interest rate first.
As you pay off your highest-interest debt, you move onto the next debt with the second highest rate. You keep repeating this process, moving up the list from the highest rate debt to the lowest. Eventually, all your debt will be paid in full.
But it will probably take longer than the Snowball Method.
Why is this method actually more efficient? Because interest is expensive. You want to end your borrowing relationship with the debt that’s costing you the most money first. But progress is a lot slower and a lot of people lose their motivation – their snowball begins to melt.
If you have the patience and the discipline, the slower progress will ultimately keep more of your hard-earned bacon in your pocket. Of course, this is only true if you’re carrying a lot of high-interest debt, like credit cards for example.
Understanding The Two Main Types Of Interest
While most Canadians are carrying a variety of debt, credit card debt is by far the most insidious, and most expensive. That’s one of the reasons why Hardbacon built its credit card comparison tool: to let people compare credit cards for the best rate. So let’s compare how credit card interest works vs how interest on a personal loan, like a car, is calculated. Understanding the difference between simple daily interest vs. compounding interest works will help you pick the right method of debt repayment for your situation.
Daily Simple Interest
Daily simple interest is a type of interest calculation most commonly used for smaller short-term personal loans, like a car loan, for example.
If you buy a $10,000 used car and your bank finances that purchase at 4%, that’s known as your annual rate. The annual rate is broken down and charged daily between your scheduled monthly payments. If your annual rate is 4% your daily rate would be 0.01%
4% / 365 = 0.01%
That means your car loan is charged interest on the remaining balance at a rate of 0.01% per day. That interest accumulates until you make your scheduled monthly payment. Part of your payment will clear off the accumulated interest, the rest will go to your principal. As you pay down your loan each month, more of your payment will go to your principal and less will go to interest.
A $10,000 car loan on a 5-year term with a 4% annual interest rate, your monthly payment would be $184.17. When you make your first payment $32.88 will go to interest and $151.29 will go to your principal.
Now that your principle has come down, the interest charged will be calculated on that new lower balance owing. So when you make your next payment, even more of it will go to your principal and even less to interest.
Fast forward 2.5 years. You’re halfway through your loan term and you haven’t missed a single payment. You have $5000 left owing. Your minimum monthly payment of $184.17 hasn’t changed, but now only $16.44 will go to interest and $167.77 will go to your principal.
On a personal installment loan, the term and payment are both fixed. That means your payment won’t change. If you never paid a penny over the fixed monthly payment amount, it will be paid off according to the contract term, and that’s usually about 60 months (5 years) for a car loan.
You will pay off your $10,000 car loan in exactly 5 years and it will cost $1,050.
Pretty straightforward right?
Compound Interest or Revolving Interest
Compound interest is quite a bit more complicated, and quite a bit more sneaky. From a savings and investment standpoint, compound interest is the secret sauce to growing your wealth. If you were to put that $10,000 in a high-interest savings account, you’re automatically earning compound interest.
Let’s pretend you opened a new high-interest savings account through a virtual bank like Equity Bank. Instead of buying that $10,000 used car, you put that money into your EQ savings account and they’re going to pay you 1.25% annually. That means in the first year, you’ll make $125 and it will get added to your account, bringing your balance up to $10,125.00.
You roll into your second year with $10,125 sitting in that account and now you’re making 1.25% interest on $10,125.00. At the end of that second year, you will have made $126.56, and it gets added to your account. Now your balance is up to $10,251.56. Then, next year you make 1.25% on your balance of $10,251.56. See where we’re going with this?
Credit card interest works kind of like that, but way the heck more complicated. Like, a lot more. Let’s break it down to its basic principle.
What you know as a loan is actually an investment by the person or institution who gave you that loan. They want a return on that investment because they want to grow their wealth. And since credit cards are unsecured loans, which means you didn’t have to give anything in return (like the title to your car), if you default on your credit card the lender is at a total loss. That’s because there’s literally nothing for them to repossess in order to re-sell and recuperate some of their loss.
Revolving debt, the kind you can access quickly and repeatedly like credit cards and lines of credit, is almost always charged as compound interest. In the lending world, interest on these revolving credit accounts is referred to as revolving interest.
Riskier investments come with higher potential rewards. That’s what makes them worth investing in. Credit cards are high risk. So the interest rates are way higher and they compound, just like in our savings account example.
Most credit cards are charged the industry standard rate of about 19% a year, give or take a point or two. That 19% is broken down to a per-day rate, so 19% divided by 365 days in the year is 0.052% per day on your balance.
That’s not so scary.
Except that a credit card is revolving debt, which means you can pay it down and use it again, and repeat that process over and over. And it’s instant access to credit. That means you might owe $10,000 today, but then the bumper falls off your car so tomorrow you owe $12,000 after getting it fixed. So tomorrow, you get charged that daily rate on the new higher balance.
Yesterday you owed $10,000 and your daily rate is 0.052%. That interest was added to your balance owing, bringing it up to $10,005.20. But you just charged your car repair to that credit card. So your new balance is $12,005.20. Today, you will get charged the daily rate of 0.052% on $12,005.20 and it gets added to your balance, bringing it up to $12,011.44. You got charged interest on interest!
You got charged interest on the $2000 you used to fix the car. And you got charged interest on the $5.20 which was already an interest charge on the original $10,000 balance before your car repair.
Your credit card’s monthly payment is usually calculated as 3% of the outstanding balance or $10, whichever is more. On a credit card now owing $12,011.44, your minimum payment would be about $360.
If you only ever made the minimum payment and not a penny more, it would take you 25 years to pay it off and cost you about $13,200 in pure interest.
It doesn’t matter if the rate is high or low. Let’s circle back to your car loan, which was $10,000 financed over 5 years at a 4% simple daily interest rate. Making only the minimum payment, over 5 years you’d pay $1,050 in just interest.
But if you had a line of credit owing $10,000 at a 4% revolving interest rate it would cost you more than your fixed installment car loan. Why? Because, again, it’s revolving compound interest.
The payment and the rate may be considerably lower, but just like a credit card, that minimum payment isn’t going to pay off your balance anytime soon.
In fact, a $10,000 line of credit financed at 4% will take you 11.5 years to pay off and cost you $1,740.00 of interest, assuming you just did the minimum payment and not a cent more.
That’s almost $700 more interest than the simple daily rate on your car loan of the same amount at the same rate.
Snowball Or Avalanche: Which One Is Right For You?
Here’s the mind-blowing secret you’ve been waiting for…
It literally doesn’t matter which method you choose. Because a serious debt reduction plan is a lifestyle change. The very best plan to pay off your debt is the plan you’ll actually stick to.
If you’re the type of person who thrives on constant feedback and seeing improvements quickly, then you might want to use snowball. If you’re the penny-pinching bean counter who will walk a mile to save a buck – the avalanche method has your name written all over it.
The point of offering two methods is this: you have a choice in how you do it, but it needs to get done. Even if you’ve never missed a payment, carrying a lot of debt can still hurt your credit score. Not to mention it can hold you back from other opportunities like investing, buying a house or turning that great idea into your own business.
Remember, it’s not just about the balances owing or how high the rate is. As these examples illustrate, it’s also how the rate is charged. The exact same interest rate will cost you a lot more on something like a line of credit or credit card than it will on an installment loan of the same amount.
Don’t just prioritize your debts from lowest balance to highest, or highest rate to lowest. Take a good hard look at the type of interest on each of your debts. Then use a repayment calculator to see how much interest you’re actually being charged in dollars and cents.
If I had to do it, I would aggressively pay down credit cards first followed by lines of credit. Once those are cleared up, I would tackle the installment loans that are costing me the most interest in dollars.