Debt-snowball method
From Wikipedia, the free encyclopedia
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. This method has gained more recognition recently due to the fact that it is the primary debt-reduction method taught by many financial and wealth experts.
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[edit] 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.
- Then, add the old minimum payment from the first debt to the extra amount, and apply the new sum to 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 as it does on finance; by paying the smaller bills first, the individual, couple, or family sees fewer incoming payment requests as more bills are paid off, thus giving ongoing positive feedback on their progress towards eliminating their debt.
All retirement contributions are to be halted during the debt snowball, thus freeing up more money to pay down the debt snowball. Many dispute this practice, citing the cost of compounding interest to be greater than the gains of paying off debt. Some compromise by reducing retirement contributions to only what a company will match with an employee. Many financial and wealth experts teach that this halting of retirement contributions should last no more than two years.
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 plan's 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.
[edit] Simple Example
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Ignoring interest rates, let's pretend you have the following debt (along with the minimum payments):
- Car Payment - $2500 balance - $150/month minimum
- Credit Card A - $250 balance - $25/month minimum
- Loan - $5000 balance - $200/month minimum
- Credit Card B - $500 balance - $26/month minimum
Your minimum payments for all debt would be $401 per month. You would order your debts in the following order (lowest to highest):
- 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
Now, assuming you had $100 extra per month to send in, you would apply that $100 to the Credit Card A so that the payment for it would be $125 per month and the other debt would receive the minimums.
After Credit Card A is paid off (in two months), you would apply the extra $100 to Credit Card B PLUS the $25 you were sending in to Credit Card A. So now your payment to Credit Card B would be: $26 normal minimum + $25 that you normally sent in to Credit Card A + $100 that you are able to send extra.
Your payment to Credit Card B would be $151 instead of $26. Therefore, you would pay it off much faster. Then, when Credit Card B is paid off, you would now send in the following to the Car Payment: $150 normal minimum + $25 that you normally sent in to Credit Card A + $26 that you normally sent in to Credit Card B + $100 that you are able to send extra
Your payment to Car Payment would now be $301 instead of $150.
If you didn't have $100 extra (or any extra amount) the debt snowball would be the same minus $100 per month.
[edit] 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.
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).[1]
