Debt Snowball: Overview, Pros and Cons, Application

There are a variety of different strategies consumers can use to pay off their debts. With the debt snowball method, they start with their smallest debts and work their way up to the largest ones. Here is how debt snowball works, its pros and cons, and a look at some alternatives.

How the Debt Snowball Method Works

The debt snowball method was made popular by Dave Ramsey, the host of a personal finance radio show and a best-selling author. It involves these steps:

• First, list all of your non-mortgage debts in order of their balances, from smallest to largest.
• Then pay as much money as possible each month toward the debt at the top of the list, while making minimum payments on all the remaining debts.
• After the smallest debt has been paid off, start putting your extra money toward the next one on the list, while continuing to make only minimum monthly payments on all the others.
• Keep this up until all of your debts have been paid in full.

The various debts' interest rates are not a factor in the debt snowball method. While it would most likely cost you less in interest in the long run to use an alternative method called debt avalanche (see below), debt snowball advocates say it can be more effective because of the psychological benefits of achieving a win each time a debt is paid in full.

Pros and Cons of the Debt Snowball Method

Like many other financial strategies, the debt snowball method has both advantages and disadvantages.

Pros

• 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, since it doesn't require you to compare annual percentage rates (APRs) for different debts. You simply need to know the balance of each debt to rank them in priority.

Cons

• Interest. The debt snowball method is not necessarily the best choice for saving money on interest. Because you're prioritizing balances over interest rates and only making minimum payments on debts that are low on the list, you could end up paying considerably more in interest over time.
• Time. Again, since the debt snowball method focuses on repaying debts according to their balances, and can allow large, high-interest debts to grow even bigger, it may take you longer to pay off your total debt.

How to Apply a 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 paying off your three sources of debt: $2,000 worth of credit card debt (with a minimum monthly payment of $50), $5,000 in 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 need a total of $700 to cover the minimum monthly payments on the auto and student loans. That leaves you with $300 to put toward your credit card debt.

Once the credit card debt has been completely paid off, the extra payment can go toward retiring the second-largest debt: the auto loan. After making the $400 minimum monthly payment on the student loan, you can put $600 a month toward the auto loan,. Once the auto loan is paid off, the full $1,000 can go toward the student loan until it, too, is paid off and you are debt-free (assuming you haven't run up any other debt in the meantime).

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—known as the debt avalanche method—should 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 balance 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 debt snowball and debt avalanche methods. You'll be practicing both at the same time.

The Bottom Line

The debt snowball method is one way to get out of debt. It may not save you the most money in the long run, compared to other methods, but it could give you some extra motivation to stay on track.