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.The debt-snowball method of debt repayment is a form of debt management that is most often applied to repaying revolving credit — such as credit cards. 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.
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.