Remember as a kid when it would snow, and you couldn’t wait to get out and build a snowman? How it took a bit of effort to get that snowball started, but soon it began gathering momentum, getting bigger faster and faster? Debt reduction works in much the same way…and when all your debt is paid off, you’ll feel just as giddy as you did when you were little.
How The Debt Snowball Method Works
The debt snowball method is a debt reduction strategy where you pay off your debt starting with the smallest bills and progressing to the larger ones, regardless of the interest rate. Once you’ve paid your smallest debt in full, you take the money you were paying on that debt for the next smallest balance. As you do this over and over, you gain more momentum with each one – like a snowball getting bigger and bigger as rolls.
Six Steps To Debt Reduction
- With the exception of your mortgage, list all your debts from smallest to largest. This is determined by the amount owed, not the interest rate. However, if two debts are really close in amount, list the higher interest rate one first.
- Pay the minimum amount on every debt except the smallest one.
- Determine how much extra you can apply to the smallest debt.
- Pay the minimum payment, plus the extra amount on your smallest debt until it is paid in full. (note, for some loans such as car loans, you should contact the lender to inform them that the extra amount should go towards principal – not just the next payment which includes interest).
- Once the first debt is paid in full, add the minimum payment of the next smallest debt, plus any additional funds, to the next smallest debt.
- Repeat until all debts are paid in full!
Example of the Debt Snowball
Let’s say you have the following four debts you need to pay off:
- $2,000 credit card debt – $40 minimum payment.*
- $5,000 student loan – $59 minimum payment.**
- $7,500 credit card debt – $150 minimum payment.*
- $12,000 car loan – $232 minimum payment.***
Using the debt snowball method, you would pay the minimum amount on each debt except the $2,000 credit card payment. Let’s say you have an extra $500 a month to put towards that first debt. Combining the extra $500 with your minimum payment of $40 for a total payment of $540 means you’ll pay that baby off in 4 months.
Now, you’ll take that $540 from your credit card debt and add it to the $59 minimum payment on your student loan. By paying $599 each month on your student loan, you’ll be able to say “Adios” to your remaining student debt in 9 months!
Next, you’ll add that $599 to second credit card’s minimum monthly payment of $150, for a total of $749. Now you’re saying “Sayonara” to the rest of your credit card debt in 11 months…Wahoo!!! With 3 down and 1 to go, you’re really rolling (see the snowball reference there?)!
By the time you start paying more than the minimum on your car loan, you’re able to add $749 to your minimum monthly payment of $232. At $981 total per month, your car loan will be paid off in full in 9 months. Thanks to your commitment and focus, you’re debt free in 33 months!
Why It Works
The reason the debt snowball method works has less to do with math and more to do with the psychological benefit of seeing results sooner. By paying the smallest debts first, you’ll see fewer bills as they’re paid off which gives ongoing positive feedback toward the progress of eliminating debt. A 2012 study by Northwestern’s Kellogg School of Management found that “consumers who pursued the “small victories” strategy was more likely to eliminate their entire debt balance” than trying to pay off their high-interest rate credit card first.
A study in the Harvard Business Review showed similar results. Participants who were asked to concentrate on making payments to a single account vs. dispersing them across many showed higher motivation, repaying their debt more quickly.
Choose The Plan That Works For You
While paying off your debts in order of highest to lowest interest rate may be cheaper or faster, if it’s a plan you abandon, then it won’t work. If achieving subgoals (like with the debt snowball method) can help you stick to your plan of reducing or eliminating your debt, it is worth the extra you may pay in interest.