What is a Debt Snowball?

A Highly Recommended Method to Pay off Creditors

Jun 29, 2009

When debts accumulate and threaten one's financial prosperity, the debt snowball is a great counter toward the possibility of a lifetime of bondage to creditors.

For those not familiar with the concept, the debt snowball is a method of paying off debt by listing credit accounts in order from smallest to largest, and then systematically reducing and eliminating them one at a time.

Financial expert Dave Ramsey promotes this as he has seen it work for many people, stating that the snowball is not the best way to pay down debt, mathematically, but in the sense of human behavior, it is very effective.

Smallest Debts up Front

As stated earlier, to apply this method of paying down debt, simply list all accounts. Do not take into account accruing interest. Ramsey notes in his book, The Total Money Makeover, that there are some exceptions, such as debts to the IRS that are time-sensitive that can be heck if not paid sooner rather than later. He also states in his book that if amounts owed are close, then the one with the higher interest rate should be paid first.

Apply Minimum Required Payments to all Debts but one

Now that debts are listed in order, it is time to apply payments. Rather than spread load payments among several debts- as many people do to gain a little ground on each account- pay the minimum on every account except the smallest.

This will allow for significant reductions on one account, eliminating it sooner.

For example, "Marcy" is a 23-year-old Human Resources Manager with TD Bank. She earns $40,000 a year and has 5 credit accounts:

Prior to creating a debt snowball, Marcy was applying her minimum payments to her loans plus $50 extra on each one. If she continued doing so, she would pay off her dentist in 10 months.

But with the debt snowball, Marcy will pay the minimum payments on all loans, and apply the $50 from each of the other accounts to her dentist. The result will be a balance of $250 after one month, and then $0 after two.

Now that Marcy has paid off her dentist, she will apply the minimums to every account except the MasterCard. Here, Marcy will pay the minimum payment of $22, according to Bankrate.com, plus $250.

From the start of the debt snowball, Marcy will eliminate two debts after approximately six months, whereas spread loading the payments would not have paid off one in this time.

A bonus to paying off these debts is that Marcy's net worth will increase as will her cash flow, improving her overall financial health.

Debts That are not Part of the Snowball

Debts in excess of more than half a person's yearly income, such as a home mortgage or large student loans, do not belong in the snowball. They will be addressed, but only after more manageable debts are eradicated.

The debt snowball is not always the best way to eliminate debt, but it is a plan that is very efficient, especially in the initial stages when paying off small accounts. After the discipline that it takes to dedicate oneself to eliminating accounts, such as Marcy's, a person can save up to purchase vehicles and homes with cash, or have substantial down payments for them.

Opposition to the Debt Snowball

This method is not universally recommended in the financial industry. Suze Orman recommends in her book, The Courage to be Rich, to pay off debts in order from highest interest rate to lowest. Ramsey recognizes this method as superior in eliminating debt, but believes it will not be as helpful. His reasoning: people in financial binds need the instant gratification of eliminating a small debt early, just as they needed the instant gratification that led to its initial accumulation.

To complement Orman's idea, financial blogger Trent Mann recommends the same method as a much more efficient means to eliminating debt.

Regardless of which method one chooses, it is crucial that one is chosen. A life without debt is a life with more options. And, as loosely stated in Proverbs 22:7, a life with revolving debt is a life with revolving bondage, as a person who borrows will always be in servitude to he who lends.

Sources

Ramsey, Dave. The Total Money Makeover. Nashville: Thomas Nelson, 2003. Print.

The copyright of the article What is a Debt Snowball? in Personal Debt Management is owned by Christopher Pascale. Permission to republish What is a Debt Snowball? in print or online must be granted by the author in writing.