Last week as part of Dave Ramsey’s Baby Steps, I mentioned the debt snowball method to tackle debt. This method is very well known and is used by millions of people. Despite its popularity, it is not for everyone.
So what is the debt snowball method? It starts by ordering all of your debts from smallest to largest. Most people don’t include their mortgage in this list. They then allocate all extra resources to attack the smallest debt while only paying the minimum payment on all other debts. They continue to attack the smallest debt until it is paid off at which point they move to the next smallest until all their debt is tackled.
Pros: With this method people tend to feel like they are seeing results in a relatively short amount of time. This momentum is encouraging and often helps motivate the individuals to stay focused on getting out of debt. This is a huge plus because oftentimes, when people try to get out of debt, they get discouraged or lose motivation only a few months in.
Cons: This method gives no attention to interest rates. This could cause someone to pay more in interest if they are paying only the minimum payment on a debt such as a credit card (very high interest rate). The best method of debt reduction (dollar for dollar) is to focus on the highest interest rates first and then move to debts with lower interest rates.
Let’s run an example to get an idea of what the numbers might look like.
Let’s say we have the following debt:
-$12,000 in students loans at 6% with minimum payment of $150/month
-$10,000 auto loan at 5.5% with minimum payments of $300/month
-$15,000 credit card at 20% with minimum payments of $300/month
And we’ll assume that we have $12,000 a year ($1,000/month) to put towards paying down debt. If we use the debt snowball method (1st auto loan, 2nd student loans, and 3rd credit card), we would pay off all the debt in about 5 years and would pay about $11,600 in interest.
Now, if we switch our approach to put all extra money towards the debt with the highest interest rate (1st credit card, 2nd students loans, and 3rd auto loan) it would take 3 months less (4 years and 9 months) to get out of debt and we’d only pay $8,217 in interest. That is more than $3,000 saved by one small change in strategy.
Conclusion: While the snowball method is not technically the best method, it does work for a lot of people because it helps them actually stick to their plan. Debt reduction can be very challenging for some and the best method is the one that we can actually implement. Regardless of the method, everyone has to look at their situation and decide what works best for them and their lives, taking full responsibility for all the pros and cons of their choice.