Debt snowball method

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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 payment on larger debts. Once the smallest debt is paid off, one proceeds to the next larger debt, and so forth, proceeding to the largest ones last. [1] This method is sometimes contrasted with the debt stacking method, also called the debt avalanche method, where one pays off accounts on the highest interest rate first. [2] [3]

Contents

The debt snowball method 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. [4]

Methodology

The basic steps in the debt snowball method are:

  1. 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.
  2. Commit to pay the minimum payment on every debt.
  3. Determine how much extra can be applied towards the smallest debt.
  4. 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.
  5. 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.
  6. Repeat until all debts are paid in full. [5] [6] [7]

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, hence the name. [8]

The theory appeals to 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.

Pro and cons

The debt snowball method goal is to motivate the person in debt to continue paying off the debt. There is a reward to seeing the first smaller debt go away. Feelings is how many get in debt, thus feelings is how one gets out of debt. The plan is easy and simple to follow. [6]

The other method, Debt Avalanche, paying of highest interest rate first, will save the person in interest payment, if they stay motivated. The small debt, with lower interest rate will stay around longer. The debt snowball method has larger high-interest debts around longer, thus may take more time to pay off. [6]

Example

An example of the debt snowball method in action is shown below. In a real payoff scenario the different interest rates on debts will affect payoff times and might make the method less efficient than other plans. However, for the sake of illustrating the method, the example ignores accruing interest.

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):

The additional $100 is first directed toward Card A and, together with the $25 minimum payment, pays off the balance in two months. This is illustrated in the following table, with the prioritized debt indicated in bold.

Month Card A Card B Car Personal
0 25050025005000
1 12547423504800
2 044822004600

Paying off Card A leaves $125 free for additional payment: the original $100, plus the $25 previously committed to minimum payments on Card A. This amount is added to Card B's $26 minimum payment, thereby paying it off in three more months.

Month Card B Car Personal
2 44822004600
3 29720504400
4 14619004200
5 017504000

A total of $151 is then free for additional payment, and is applied to the car loan for a total monthly car payment of $301. This pays off the car loan in another six months.

Month Car Personal
5 17504000
6 14493800
7 11483600
8 8473400
9 5463200
10 2453000
11 02800

The available $301 would then be added to the personal loan's minimum payment for a total payment of $501. This would pay off the personal loan in another six months, leaving the debtor debt-free after a total of 17 months. Since the example omits interest, any payment order could pay off the debts in the same amount of time, but the snowball method avoids long waits between successive payoffs. If the debtor had prioritized debts in the reverse order, the first payoff (Card A) would have taken ten months and the rest an additional seven.

Effectiveness

In situations where one debt has both a higher interest rate and higher balance than another debt, the debt snowball method prioritizes the smaller debt even though paying the larger, higher-interest debt would be more cost-effective. Several writers and researchers have considered this contradiction between the method and a strictly mathematical approach. In a 2012 study by Northwestern's Kellogg School of Management, researchers found that "consumers who tackle small balances first are likelier to eliminate their overall debt" than trying to pay off high interest rate balances first. [9] A 2016 study in Harvard Business Review came to a similar conclusion:

We tested a variety of hypotheses and ultimately determined that it is not the size of the repayment or how little is left on a card after a payment that has the biggest impact on people's perception of progress; rather it's what portion of the balance they succeed in paying off. Thus focusing on paying down the account with the smallest balance tends to have the most powerful effect on people's sense of progress – and therefore their motivation to continue paying down their debts. [10]

Author and radio host Dave Ramsey, a proponent of the debt snowball method, concedes that an analysis of math and interest 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 he argues that people trying to reduce debt need "quick wins" (i.e., paying off the smallest debt) in order to remain motivated toward debt reduction. Ramsey Solutions has done studies that show motivation is more effective than interest rates. [11]

Research by Moty Amar and colleagues agreed that debtors are inclined to pay small debts first, which they attributed to "debt account aversion", the desire to reduce the number of outstanding debts regardless of balance or interest expense. [12] However, they also found that when debtors are restricted from fully paying debts and are shown the interest that will accrue as a result of their choice, they make the mathematically optimal decision. [12]

See also

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References

  1. ↑ "How to Get Out of Debt With the Debt Snowball Plan". Ramsey Solutions.
  2. ↑ "Debt Snowball Vs. Debt Stacking". About.com. Archived from the original on 2015-06-30. Retrieved 2015-06-28.
  3. ↑ "How Does Debt Stacking Work?". Synonym.com.
  4. ↑ "How a `debt snowball` plan works" Archived 2014-02-22 at the Wayback Machine , All About Money
  5. ↑ "How the Debt Snowball Method Works". Ramsey Solutions.
  6. 1 2 3 "Debt Snowball: Overview, Pros and Cons, Application". Investopedia.
  7. 1 2 "Paying Down Credit Card Debt | Questrom School of Business". www.bu.edu.
  8. ↑ Gobler, Erin (August 10, 2023). "What's the debt snowball method?". USA TODAY Blueprint.
  9. ↑ "The 'snowball approach' to debt - Kellogg School of Management".
  10. ↑ "Research: The Best Strategy for Paying Off Credit Card Debt". Harvard Business Review. Retrieved 2017-03-17.
  11. ↑ Dave Ramsey (2009). The Total Money Makeover: A Proven Plan for Financial Fitness. Thomas Nelson Inc, ISBN   978-1595550781
  12. 1 2 Amar, Moty; Ariely, Dan; Ayal, Shahar; Cryder, Cynthia E.; Rick, Scott I. (2011). "Winning the Battle but Losing the War: The Psychology of Debt Management". Journal of Marketing Research. 48: S38–S50. doi:10.1509/jmkr.48.SPL.S38. S2CID   55616109. SSRN   1760528.
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