Debt-snowball method
Encyclopedia
The debt-snowball method is a debt reduction strategy, whereby one who owes
on more than one account
pays off the accounts starting with the smallest balances
first while paying the minimum on larger debts. Once the smallest debt is paid off, one proceeds to the next slightly larger small debt above that, so on and so forth, gradually proceeding to the larger ones later.
repayment is a form of debt management that is most often applied to repaying revolving credit
— such as credit card
s. Under the method, extra cash is dedicated to paying debts with the smallest amount owed.
This method has gained more recognition recently because it is the primary debt-reduction method taught by many financial and wealth experts. However, it has always existed, as people have a tendency to want to take care of smaller, easier-to-take-care-of things first.
In theory, by the time the final debts are reached, the extra amount paid toward the larger debts will grow quickly, similar to a snowball rolling downhill gathering more snow (thus the name).
The theory works as much on human psychology; by paying the smaller debts first, the individual, couple, or family sees fewer bills as more individual debts are paid off, thus giving ongoing positive feedback on their progress towards eliminating their debt.
A first home mortgage is not generally included in the debt snowball, but is instead paid off as part of one's larger financial plan. As an example, many financial plans pay off home mortgages in a later step, along with any other debt which is equal to or greater than half of one's annual take-home pay.
The issue of whether one should make retirement contributions during the debt reduction process is a matter of dispute among proponents of this method:
(This example does not add in the accruing monthly interest of the credit cards and loans making the balance amounts higher and payoff time longer.)
A person has the following amounts of debt and additional funds available to pay debt (the debt is listed with the smallest balance first, as recommended by the method):
Under the debt-snowball method, payments for the first two months would be made to debtors as follows:
After two months (presuming the person has not added to the balances, which would defeat the purpose of debt reduction), Credit Card A would have been paid in full, and the remaining balances as follows:
The person would then take the $125 previously used to pay off Credit Card A and apply it as additional payment to the Credit Card B balance, which would make payments for the next three months as follows:
After three months Credit Card B would be paid in full (the final payment would be $146), and the remaining balances would be as follows:
The person would then take the $151 previously used to pay off Credit Card B and apply it as additional payment to the car loan balance, which would make payments as follows:
It would take six months to pay the car loan (the final payment being $240), whereupon the person would then make payments of $501/month toward the loan (which would have a $2800 balance) for six months (with the last payment at $234).
Thus in 17 months the person has repaid four loans, with two of them being paid in a mere five months and three within one year.
A secondary benefit of the smallest-balance plan is the reduction of total amount owed to lenders in a single month. This is a risk reduction in the event of a lost job or emergency.
, a proponent of the debt-snowball method, concedes that "the math" leans toward paying the highest interest debt first; however, based on his experience, Ramsey states that personal finance is "20 percent head knowledge and 80 percent behavior" and that people trying to reduce debt need "quick wins" in order to remain motivated toward debt reduction.
The Debt-Snowball method is only for those on high enough incomes to be able to meet all the minimum repayment requirements on their debts. This method could instead lead to problems for those who are struggling to meet these minimum payments demands. In this circumstance, an individual should not be advised to pay creditors differing amounts as this could count as non-equitable repayment, leading to problems (e.g. with going bankrupt, or with maintaining non-equitable repayments over longer periods).
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
on more than one account
Account
Accounting is a systematic way to record transactions.An Account refers to assets, liabilities, income, expenses, and equity, as represented by individual ledger pages, to which changes in value are chronologically recorded with debit and credit entries. These entries, referred to as postings,...
pays off the accounts starting with the smallest balances
Balance (accounting)
In banking and accountancy, the outstanding balance is the amount of money owed, , that remains in a deposit account at a given date, after all past remittances, payments and withdrawal have been accounted for. It can be positive or negative ....
first while paying the minimum on larger debts. Once the smallest debt is paid off, one proceeds to the next slightly larger small debt above that, so on and so forth, gradually proceeding to the larger ones later.
Overview
The debt-snowball method of debtDebt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
repayment is a form of debt management that is most often applied to repaying revolving credit
Revolving credit
Revolving credit is a type of credit that does not have a fixed number of payments, in contrast to installment credit. Examples of revolving credits used by consumers include credit cards. Corporate revolving credit facilities are typically used to provide liquidity for a company's day-to-day...
— such as credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
s. Under the method, extra cash is dedicated to paying debts with the smallest amount owed.
This method has gained more recognition recently because it is the primary debt-reduction method taught by many financial and wealth experts. However, it has always existed, as people have a tendency to want to take care of smaller, easier-to-take-care-of things first.
Methodology
The basic steps in the debt snowball method are as follows:- List all debts in ascending order from smallest balance to largest.
- This is the method's most distinctive feature, in that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the debt with the higher interest rate would be moved above in the list.
- Commit to pay the minimum payment on every debt.
- Determine how much extra can be applied towards the smallest debt.
- Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off.
- Note that some lenders (mortgage lenders, car companies) will apply extra amounts towards the next payment; in order for the method to work the lenders need to be contacted and told that extra payments are to go directly toward principal reduction. Credit cards usually apply the whole payment during the current cycle.
- Once a debt is paid in full, add the old minimum payment (plus any extra amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new sum to repaying the second smallest debt.
- Repeat until all debts are paid in full.
In theory, by the time the final debts are reached, the extra amount paid toward the larger debts will grow quickly, similar to a snowball rolling downhill gathering more snow (thus the name).
The theory works as much on human psychology; by paying the smaller debts first, the individual, couple, or family sees fewer bills as more individual debts are paid off, thus giving ongoing positive feedback on their progress towards eliminating their debt.
A first home mortgage is not generally included in the debt snowball, but is instead paid off as part of one's larger financial plan. As an example, many financial plans pay off home mortgages in a later step, along with any other debt which is equal to or greater than half of one's annual take-home pay.
The issue of whether one should make retirement contributions during the debt reduction process is a matter of dispute among proponents of this method:
- Some argue that all contributions are to be halted during the debt snowball, thus freeing up more money to pay down the debt snowball.
- Others dispute this practice, citing the cost of compounding interest to be greater than the gains of paying off debt.
- Some compromise by arguing that retirement contributions should be reduced to only the minimum amount that the employer will match with an employee, but not eliminated completely.
- Many financial and wealth experts teach that this halting of retirement contributions should last no more than two years.
Example
An example of the debt-snowball method in action is shown below.(This example does not add in the accruing monthly interest of the credit cards and loans making the balance amounts higher and payoff time longer.)
A person has the following amounts of debt and additional funds available to pay debt (the debt is listed with the smallest balance first, as recommended by the method):
- Credit Card A - $250 balance - $25/month minimum
- Credit Card B - $500 balance - $26/month minimum
- Car Payment - $2500 balance - $150/month minimum
- Loan - $5000 balance - $200/month minimum
- The person has an additional $100/month which can be devoted to repayment of debt.
Under the debt-snowball method, payments for the first two months would be made to debtors as follows:
- Credit Card A - $125 ($25/month minimum + $100 additional available)
- Credit Card B - $26/month minimum
- Car Payment - $150/month minimum
- Loan - $200/month minimum
After two months (presuming the person has not added to the balances, which would defeat the purpose of debt reduction), Credit Card A would have been paid in full, and the remaining balances as follows:
- Credit Card B - $448
- Car Payment - $2200
- Loan - $4600
The person would then take the $125 previously used to pay off Credit Card A and apply it as additional payment to the Credit Card B balance, which would make payments for the next three months as follows:
- Credit Card B - $151 ($26/month minimum + $125 additional available)
- Car Payment - $150/month minimum
- Loan - $200/month minimum
After three months Credit Card B would be paid in full (the final payment would be $146), and the remaining balances would be as follows:
- Car Payment - $1750
- Loan - $4000
The person would then take the $151 previously used to pay off Credit Card B and apply it as additional payment to the car loan balance, which would make payments as follows:
- Car Payment - $301 ($150/month minimum + $151 additional available)
- Loan - $200/month minimum
It would take six months to pay the car loan (the final payment being $240), whereupon the person would then make payments of $501/month toward the loan (which would have a $2800 balance) for six months (with the last payment at $234).
Thus in 17 months the person has repaid four loans, with two of them being paid in a mere five months and three within one year.
Benefits
The primary benefit of the smallest-balance plan is the psychological benefit of seeing results sooner. Retirement contributions should start once your expected investment yield is higher than the next highest debt interest rate (generally 8% for a balanced portfolio).A secondary benefit of the smallest-balance plan is the reduction of total amount owed to lenders in a single month. This is a risk reduction in the event of a lost job or emergency.
Criticism
People with more financial discipline can get ahead quicker by paying off the credit cards and loans with the higher interest rates first. This will minimize costs to become debt-free faster than the smallest-balance approach. Dave RamseyDave Ramsey
David L. Ramsey III is an American financial author, radio host, television personality, and motivational speaker.Ramsey's syndicated radio program The Dave Ramsey Show is promoted with a tagline that "It's about your life and your money," and it is heard on over 450 radio stations throughout the...
, a proponent of the debt-snowball method, concedes that "the math" leans toward paying the highest interest debt first; however, based on his experience, Ramsey states that personal finance is "20 percent head knowledge and 80 percent behavior" and that people trying to reduce debt need "quick wins" in order to remain motivated toward debt reduction.
The Debt-Snowball method is only for those on high enough incomes to be able to meet all the minimum repayment requirements on their debts. This method could instead lead to problems for those who are struggling to meet these minimum payments demands. In this circumstance, an individual should not be advised to pay creditors differing amounts as this could count as non-equitable repayment, leading to problems (e.g. with going bankrupt, or with maintaining non-equitable repayments over longer periods).