Debt can feel abstract until the numbers are laid out. This lesson explains how interest builds on a balance, what a minimum payment does and doesn't do, and how the "snowball" and "avalanche" methods work. It describes these methods because people often ask about them; it doesn't recommend one, and it doesn't consider anyone's own situation. All figures are invented for illustration.
Principal, interest and APR
The principal is the amount borrowed or still owed, not counting interest. Interest is the price of borrowing, charged as a percentage of the principal. For credit cards and many loans, that price is expressed as an APR, or annual percentage rate: the yearly rate.
Interest is usually charged more often than once a year. For a rough monthly illustration, divide the APR by twelve. A 24% APR works out to about 2% a month, so a $1,000 balance would collect about $20 of interest in a month. Many card issuers actually apply a daily rate to the balance each day, so a real statement will differ a little, but dividing by twelve shows the idea.
What a minimum payment does
Credit cards ask for a minimum payment each month. The card agreement explains how it is calculated, and it is often a small share of the balance. Paying at least the minimum by the due date keeps an account current, but the minimum isn't set to pay the balance off quickly.
Here is why. Each payment first has to cover the interest that built up that month; only the rest reduces the principal. Using the example above:
- A payment of $25 against $20 of interest reduces the principal by just $5.
- A payment of $100 against the same $20 of interest reduces the principal by $80.
When most of each payment goes to interest, the balance falls slowly and the total interest paid over time grows. If a payment is smaller than the month's interest, the balance doesn't fall; it grows. The debt payoff illustration on the Tools page shows this month by month for any balance, rate and payment.
Federal law requires credit card statements to show this effect. Under 15 U.S.C. §1637(b)(11), as amended by the Credit CARD Act of 2009, each statement must carry a minimum payment warning and a table showing how many months it would take to pay the balance making only minimum payments, the total cost of doing that, and the monthly payment needed to pay it off in 36 months, along with that total cost. Many people find that table a quick way to see the long-term cost of carrying a balance.
Two payoff methods people talk about
When someone has several debts, two organizing methods come up again and again. Both involve continuing to make at least the minimum payment on every debt and directing any extra money each month toward one target debt. When the target is paid off, the money that was going to it is added to the next target, so the payment aimed at each new target grows over time. They differ only in the order of the targets.
The snowball method
The snowball method orders debts from the smallest balance to the largest, regardless of interest rate. People who use it often describe the benefit as motivation: the first account is paid off sooner, and each paid-off account is a visible milestone.
The avalanche method
The avalanche method orders debts from the highest interest rate to the lowest, regardless of balance. In arithmetic terms, if the total paid each month is the same, directing the extra money to the highest rate first generally results in less total interest. The trade-off people mention is that the first payoff can take longer if the highest-rate debt also has a large balance.
A side-by-side example
Imagine two sample debts: a $600 store card at 18% APR and a $3,000 credit card at 26% APR. Under the snowball method, the extra money goes to the $600 card first because its balance is smaller. Under the avalanche method, it goes to the $3,000 card first because its rate is higher. Same debts, same total payment, a different order. Which order a person chooses is a personal decision that depends on more than arithmetic.
Other approaches you may hear about
People also look into consolidation loans, balance transfer offers, asking a creditor about a hardship program, or talking with a nonprofit credit counselor. Each has its own terms, fees and risks, which later lessons describe in general terms. Lesson 5 covers warning signs of debt-relief scams, such as demands for fees before any service is provided.
Sources
- 15 U.S.C. §1637(b)(11), Open end consumer credit plans: repayment information on statements
- Consumer Financial Protection Bureau, Credit cards