Thursday, February 26, 2015

The Debt Spiral

Throughout the personal finance community, there's a lot of debate over what the best way to pay off debt is.  The two main approaches are the Debt Snowball (popularized by Dave Ramsey) and the Debt Avalanche.  Both methods say to pay the minimum payment on all debts except for one, focus all extra payments on that one debt until it's paid off, then repeat with the remaining debts.  The difference comes with the order; all the methods discussed below are included in this handy Debt Calculator I made.

From a strictly mathematically perspective, the Debt Avalanche is the best method because you end up paying the least interest. With this method, you order the debts by interest rate, starting with the highest.  For example, say you had the following 5 debts:
  1. $2,500 on a credit card at 8.5%
  2. $10,000 on a home equity loan at 3%
  3. $8,000 on a student loan at 6%
  4. $7,000 on another student loan at 5.2%
  5. $18,000 on a car loan at 5.5%
Using the Debt Avalanche, you would pay them off in the following order to limit paid interest: credit card at 8.5%, student loan at 6%, car loan at 5.5%, student loan at 5.2%, and home equity loan at 3% (i.e., A, C, E, D, B as shown in the animation).  However, the first few "wins" may take awhile, and it can be harder to stay motivated.  If you don't stay motivated, you'll end up paying more in interest no matter what method you use.

Debt Avalanche
The "wins" come the quickest with the Debt Snowball method.  I used to think this method made absolutely no sense, and to a financially rational person, it doesn't.  But the people who find themselves in debt probably aren't thinking in a financially rational way, or they wouldn't be in such a mess.  These types of people need the encouragement that comes with completely paying one of their debts off.  Using the same example, the Debt Snowball would pay off the debts as follows: $2,500 credit card, $7,000 student loan, $8,000 student loan, $10,000 home equity loan, and $18,000 car loan (i.e., A, D, C, B, E).

Debt Snowball
Despite the benefits of the Debt Snowball, I have a hard time conceding that you should pay off a $3,000 debt at 2% over a $4,000 at 20%.  So, I thought, "What if I used both the interest rate and the debt balance to determine the order?" instead of one or the other.  I call this the Debt Spiral (because of how the graph looks).  Basically, you divide the debt balance by the interest rate, and then order it smallest to largest.  If you have a debt with a 0% rate,  it goes last unless it's temporarily 0%, then use the eventual interest rate.  The Debt Spiral would pay off the debts in our example in the following order: 1) $2,500 on a credit card at 8.5%, 2) $8,000 on a student loan at 6%, 3) $7,000 on another student loan at 5.2%, 4) $18,000 on a car loan at 5.5%, and 5) $10,000 on a home equity loan at 3%.

Debt Spiral
So why should you use the Debt Spiral instead of the other well-known methods?  Because it simultaneously limits the amount of interest you have to pay like the Debt Avalanche while spreading out the "wins" to keep you motivated like the Debt Snowball.  Here's an example to illustrate (all the math can be found here).
John Doe makes $50,000/year and $3,300/month take-home.  At the end of each month he has just under $45 left to save, but he has the following 4 debts
  1. $5,000 on a credit card at 18%, minimum monthly payment $125
  2. $12,000 on a personal loan at 10%, minimum monthly payment $220
  3. $6,000 on a car loan at 3%, minimum monthly payment $75
  4. $2,500 on a student loan at 5%, minimum monthly payment $35.42
John would like to use the $45** to help him pay off his debts faster, but is unsure which method would be the best.. 
If John paid only the minimum monthly payments
Debt Balance Interest Rate Pay Off Time Total Paid Interest Paid
$5,000 18 % 61 months $7,599.81 $2,599.81
$12,000 10 % 73 months $15,977.28 $3,977.28
$2,500 5.0 % 84 months $2,959.36 $459.36
$6,000 3.0 % 90 months $6,693.31 $693.31
Totals $33,229.76 $7,729.77

If John added the $45 to his Debt Avalanche
Debt BalanceInterest RatePay Off TimeTotal PaidInterest Paid
$5,00018 %39 months$6,577.83$1,577.83
$12,00010 %57 months$15,515.12$3,515.12
$2,5005.0 %59 months$2,911.94$411.94
$6,0003.0 %64 months$6,620.72$620.72

If John added the $45 to his Debt Snowball
Debt BalanceInterest RatePay Off TimeTotal PaidInterest Paid
$2,5005.0 %34 months$2,677.03$177.03
$5,00018 %49 months$7,317.78$2,317.78
$6,0003.0 %60 months$6,582.06$582.06
$12,00010 %65 months$15,884.31$3,884.31

John now wants to determine which order the Debt Spiral method would generate.  So he calculates the debt to interest ratio for each debt and orders them from smallest to largest.
Debt BalanceInterest RateDebt / Interest RatioDebt Spiral Payoff Order
$5,00018%5,000/18 = 2781
$12,00010%12,000/10 = 1,2003
$6,0003.0%6,000/3 = 2,0004
$2,5005.0%2,500/5 = 5002
John would pay the minimum payments on his student loan, personal loan, and car loan while putting every extra dime he has towards paying off the $5,000 credit card balance.  In this case, it happens to be $170 ($125 + $45).  Once the credit card is paid off, he'll have an extra $170 each month to start paying off the $2,500 student loan.  So he'll be paying $205.42 ($35.42 + $125 + $45) each month to the student loan until it's paid off.  Once the student loan is paid off, John can use the $205.42 to help pay off his $12,000 personal loan.  And finally, the $425.42 ($220 + $35.42 + $125 + $45) that was going towards the personal loan will be added to his $6,000 car loan minimum payment ($75) until it's payed off.  Now that John is debt free, he has just over $500 to save each month and hopefully keep himself out of debt!
 If John added the $45 to his Debt Spiral
Debt BalanceInterest RatePay Off TimeTotal PaidInterest Paid
$5,00018 %39 months$6,577.83$1,577.83
$2,5005.0 %46 months$2,841.63$341.63
$12,00010 %59 months$15,661.03$3,661.03
$6,0003.0 %64 months$6,621.67$621.67
As expected, the Debt Avalanche produced the lowest interest paid.  But it only beat the Debt Spiral by $76.54 or 1.2%, whereas it beat the Debt Snowball by $835.57 or 13.6%.  Also unsurprisingly, the Debt Snowball wins the contest for earliest debt paid off by a few months, but the Debt Spiral actually ties the Debt Snowball for the average time between debts paid off.
MethodTime Until 1st "Win"Average Time Until "Win"
Minimum Payments61 months77 months
Debt Avalanche39 months54.75 months
Debt Snowball34 months52 months
Debt Spiral39 months52 months

So the Debt Spiral is a win-win!

**Paying off debt quickly requires you to live differently.  In the John Doe example, he doesn't change anything about his life and so it takes several years to pay off all four debts.  Cutting expenses, getting a second job, and selling stuff would have helped him cut years off his debt sentence.