Which Loan to Prepay First: Avalanche, Snowball and Exceptions

If you have spare cash and several loans, prepay the one with the highest effective interest rate first, after keeping an emergency fund and checking for prepayment charges. That order, usually called the avalanche method, saves the most interest. The main exceptions are loans that carry a penalty for early repayment, loans whose interest earns you a tax benefit under the rules that apply to you, and situations where closing a small loan frees up monthly cash you urgently need.

A household with four loans

The family has ₹1,00,000 of bonus money after setting aside its emergency fund.

What ₹1 lakh saves in each place

As a first approximation, every rupee of principal repaid stops earning interest at that loan’s rate.

• Against the credit card: about ₹42,000 of interest avoided over a year.
• Against the personal loan: about ₹14,000.
• Against the car loan: about ₹9,500.
• Against the home loan: about ₹8,500.

The same ₹1 lakh is worth five times as much on the card as on the home loan. On a card, the rate is so high that clearing it usually beats any investment you could reasonably expect to make. The monthly compounding makes the effective annual cost even higher than 42%.

Figures are simple one-year interest on ₹1,00,000 at each rate, to show the relative size of the saving. Actual savings depend on each loan’s remaining tenure and how the lender applies prepayments.

Avalanche or snowball

Avalanche: highest rate first. Mathematically optimal. It minimises total interest.

Snowball: smallest balance first, regardless of rate. It closes loans faster, which some people find motivating, and each closed loan frees an EMI that can be rolled into the next.

In this household both methods pick the credit card, because it happens to be both the smallest and the most expensive. They diverge when a small balance carries a low rate. Suppose the family also had a ₹60,000 “no-cost EMI” on an appliance. Snowball says clear it first. Avalanche says leave it alone: at an effective rate near zero, prepaying it saves almost nothing while the card keeps charging 3.5% a month.

Snowball is defensible only when motivation is the real constraint, or when freeing a specific EMI solves an immediate cash-flow problem. Otherwise, rank by rate.

Compare effective rates, not headline rates

• Flat-rate loans. Some personal and vehicle loans quote a flat rate on the original principal. The effective reducing-balance rate is much higher, often close to double. Convert before ranking, using the flat to reducing rate converter.
• Fees and insurance bundled into the loan. A processing fee or a single-premium insurance policy financed into the loan raises its true cost.
• Tax treatment. If the interest on a loan reduces your taxable income under the tax rules applicable to you, its after-tax cost is lower than the headline rate. Whether that applies, and by how much, depends on the loan’s purpose, the regime you file under and the year, so check it for your own case rather than assuming.

The exceptions that override the ranking

1. Prepayment and foreclosure charges. Some loans, particularly fixed-rate loans and many business loans, charge a percentage of the amount prepaid. A 4% charge on a 14% personal loan with a year left can wipe out most of the benefit. Read the sanction letter or ask the lender for a foreclosure statement before deciding.

2. The emergency fund comes first. Money used to prepay a loan is hard to get back. If an emergency then forces you onto the credit card, you have swapped 8.5% debt for 42% debt. Build the fund before prepaying anything other than a card balance.

3. Cash flow can matter more than interest. If a household is struggling to meet monthly outgoings, closing a small loan with a large EMI may be the right move even if its rate is not the highest, because it reduces the monthly burden immediately.

4. Reduce EMI or reduce tenure. When you prepay a term loan, most lenders let you choose between a lower EMI and a shorter tenure. Shortening the tenure saves more interest; lowering the EMI eases cash flow. The trade-off is laid out in EMI reduction vs tenure reduction.

A sensible order for most households

1. Clear any revolving credit card balance.
2. Build the emergency fund.
3. Prepay remaining loans in order of effective after-tax rate, after checking foreclosure charges.
4. Once only low-rate loans remain, compare further prepayment with investing. Near the home loan’s rate, it becomes a genuine choice rather than an obvious one.

Where this fits

• Test the effect on your own loan: loan prepayment calculator
• The last step as a comparison: debt repayment vs investing · home loan prepayment vs SIP
• What revolving on a card really costs: how credit card interest works
• A worked plan: becoming debt-free in three years