When paying off debt, there are different strategies you may use to erase credit cards, loans and other obligations. The debt snowball is a method of debt repayment in which a person lists all of their debts from smallest to largest (not including the mortgage), then devotes extra money each month to paying off the smallest debt first, while making only minimum monthly payments on the other debts. This strategy may be appealing if you need the motivation to continue your debt repayment journey.
- Debt snowball is a strategy for paying down debts, popularized by the personal finance author Dave Ramsey.
- It involves paying your smallest debts off first, then moving on to the next smallest, and so on.
- A competing strategy is debt avalanche, which calls for paying debts with the highest interest rates off first.
- Both strategies have their pros and cons.
Understanding Debt Snowball
The debt snowball method is advocated by Dave Ramsey, the host of a popular call-in personal finance advice radio show and best-selling author of several books and programs on getting out of debt. Here's an overview of how it works:
- Debts are listed in order from smallest balance to highest.
- The debtor pays as much money as possible to the first debt each month, while making minimum payments to all the other debts.
- After the smallest debt is paid off, the debtor starts putting extra money each month toward the second-smallest debt, while continuing to make only minimum monthly payments on all the other debts.
- The debtor continues this process, paying off each debt from smallest to largest until all of the debts are paid in full.
The debts' interest rates are not a factor in selecting the order in which the debts are repaid using the debt snowball method. While repaying debts starting with the highest-interest debt and ending with the lowest-interest debt, a method called the debt avalanche, will cost debtors less in interest over the long run if they stick with the program, the debt snowball method can be more effective in reality because of the psychological benefits of generating a win each time a debt is paid in full, its proponents say.
The debt snowball method is typically applied to credit cards, though it can also be used to pay off student loans, auto loans, personal loans and other lines of credit.
Pros and Cons of the Debt Snowball Method
The debt snowball method can offer both advantages and disadvantages for debt repayment. Understanding both the pros and cons can help you decide if it's an appropriate strategy for you.
- Motivation. Paying off five debts can seem more manageable if the list is quickly whittled down to a single debt by paying off the smaller debts first. The debtor might get frustrated and quit the repayment plan if the highest-interest debt was one of the largest debts and had to be repaid at the beginning of the plan.
- Implementation. The debt snowball method is easy to implement, as it doesn't require you to compare APRs for different debts. You simply need to know the balance owed to rank each debt.
- Interest. The debt snowball method is not necessarily the best choice for saving money on interest. Because you're prioritizing balances over APRs for debt repayment, you could end up paying more money in interest over time.
- Time. Again, since the debt snowball method focuses on repaying debts according to the balance it may take you longer to pay off debts.
Creating a realistic budget that includes debt repayment and prevents you from overspending on credit is key to making the debt snowball method work.
How to Apply the Debt Snowball Strategy
Here’s an example of how a debt snowball works. Let's say you can afford to put $1,000 every month toward retiring your three sources of debt: $2,000 worth of credit card debt (with a minimum monthly payment of $50), $5,000 worth of auto loan debt (with a minimum monthly payment of $300), and a $30,000 student loan (with a minimum monthly payment of $400).
Using the snowball method of debt repayment, you would spend a total of $750 to cover each debt's minimum monthly payment. You would then put the remaining $250 toward the credit card debt because it is the smallest of the three debts.
Once the credit card debt has been completely paid off, the extra payment will go toward retiring the second-largest debt, the auto loan. At that point, you will be spending $700 a month on minimum monthly payments and have $300 extra to put toward the auto loan each month. Once the auto loan is paid off, all $1,000 will go toward the student loan until it, too, is paid in full and you are debt-free. Like a snowball, each paid-off debt frees more cash to go toward eliminating the remaining ones.
Consolidating or refinancing debts at a lower interest rate could help you to pay them off faster when using the debt snowball method.
Debt Snowball vs. Debt Avalanche
The most powerful argument for the snowball method is more psychological than financial. It assumes that the gratification you'll receive from paying off smaller debts will help keep you motivated to pay off larger ones. That may be true for many people.
However, paying off debts with the highest interest rates first (the debt avalanche method) will whittle down your total debt load faster. That's because your high-interest debts will be racking up even more interest while you're just paying the minimum due on them.
Fortunately, it's possible that your smallest debts may also be the ones with the highest interest rates. In our example above, for instance, it's likely that your credit card debt isn't just your smallest debt but the one with the highest interest rate. And your big student loan may carry the lowest interest rate.
In that case, you don't have to choose between the snowball method and the debt avalanche method. You'll be practicing both at the same time. Finally, consider comparing the best debt consolidation loans if you're interested in saving money on interest while paying off debt.