Loan repayment techniques – Snowball vs. Avalanche

As the society grows more materialistic, so does its debt burden. However, each penny borrowed today has to be returned with interest tomorrow. Paying EMI on a single loan, say education loan may not be so difficult but when one has to simultaneously pay EMIs of several loans such as Car loan, credit card dues etc, it becomes burdensome.

If one wishes to get out of this repayment cycle as soon as possible, one has to look for newer techniques. Hence, Student Cover brings you certain techniques that people have developed over time to repay their loans.

Broadly, there are two techniques – Debt Snowball technique and Debt Avalanche technique. Both have their own merits and demerits.

Debt Snowball Technique

Like a snowball which starts as a small ball of snow but gradually increases in size as it moves downhill, the snowball technique too starts off with getting rid of lower debts as soon as possible and thereby moving on to bigger debts. If one has multiple debts such as Rs. 1 Lakh debt on personal loan at 11% interest, Rs. 3 Lakh debt on car loan at 9% interest and Rs. 25 Lakh debt on education loan at 12% interest, then the snowball technique works the following way.

1. Try to repay the debt with smallest size (Personal loan in this case) completely as soon as possible.
2. While repaying the personal loan, continue paying usual EMI on other 2 loans so that you don’t default.
3. Repay personal loan by paying more than the EMI and getting rid of the loan repayments as soon as possible.
4. After repaying the personal loan, follow the same method to repay the car loan and then proceed to repaying the education loan.

However, this method has its own merits and demerits:

Merits:

1. Getting rid of even one debt obligation has psychological advantage and acts as a great morale booster.
2. Since you got rid of the loan quickly, you save yourself the debt obligation. This money you can then use to pay the other loans more quickly.
3. As smaller loan obligations cease to exist, you can repay the bigger loan by paying extra. This means your entire loan will be over before time.
4. Works well if the repayment period of bigger size debt is more than the smaller size debt.

Demerits

Since it is based on size rather than interest rate, the pressure remains still very high if the bigger size debt has high interest rate.

Repayment pressure would leave less room for maneuver in case of any financial emergency.

Debt Avalanche Technique

While the Debt Snowball Technique takes debt size into consideration, the Debt Avalanche technique takes the interest rate into consideration. All the loans to be paid are ranked according the higher interest rate. So, the loan amount having the highest interest rate is ranked no. 1.

Personal loan of Rs. 1 Lakh at ROI of 11%, car loan of Rs. 3 Lakh at ROI of 9% and an Education loan of Rs. 25 Lakh at ROI of 12%, then the Avalanche Technique works the following way:

1. You try to first completely repay the loan with highest interest rate (Education Loan)
2. While repaying the Education Loan, continue paying usual EMI on other 2 loans so that you don’t default.
3. Repay education loan completely by paying more than the EMI and getting rid of the loan repayments as soon as possible.
4. After repaying the education, follow the same method to repay the personal loan followed by car loan.

Debt Avalanche method also has its own merits and demerits:

Merits

1. You get rid of the biggest debt which eases the pressure on repayment

Demerits

1. Doesn’t work well only if the repayment period of high interest debt is more than the low interest debt.
2. It takes a long time to succeed and hence could be psychologically very stressful.
3. Your planning may fail in case of sudden rise in interest rate of one of the loans (in case of floating interest rates).

Let’s Wrap Up!

Repaying multiple debts can be a difficult task. One can use Debt Snowball or Debt Avalanche techniques to repay the debt. The Debt Snowball technique focuses on completely repaying the smaller size loan first and moving on to the larger debt. In Debt Avalanche technique focuses on repaying debt with highest interest first and then moving on to the one with lower interest rate.

Disclaimer: The content of the following article is based on the personal research of the writer. Readers are advised to exercise discretion. Student Cover will not be liable for any wrongful interpretation of the content of this article. The data given in example is imaginary and not real. Any similarity with real data is purely coincidental.