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I've noticed that the less free hard-drive I have the slower Windows 7 works. This starts at ~10GB of free space and increases dramatically towards 5GB. If I free up space Windows pops back to life.

This happens on both my laptop (4GB of RAM) and desktop (3GB of RAM)

Why does free space effect Windows performance in such a way?

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It slows because it's harder for Windows to allocate continuous blocks of space of disk, for example, for the pagefile and anything else. This means that instead of being able to slosh large amounts of data all at once, it has to read and write smaller chunks, moving the heads for each new chunk. That dramatically slows the overall data rate.

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In addition to Physical Memory, some amount of storage is used as Virtual Memory. The lower the free space available, the lower the Virtual Memory

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