The Snowball Method of Debt Reduction

There are a number ways to cut your total or monthly debt load, a few less painful than others.

The obvious one is to just pay down your debts. It can be easier said than done, and for some it may seem impossible. But there is one technique that has been used by many with great success: the snowball method (so named by Dave Ramsey).

The technique is, in essence, very straightforward. Order your debts from lowest to highest. Pay the minimum required for every monthly debt, and then allot any remaining money you can to pay the smallest debt. Thus, the smallest debt will get paid off first. This frees up yet more cash to apply to the next-smallest (now the smallest) debt. Repeat until you have accomplished the level you want.

This method has numerous advantages. You see regular, visible improvement in reducing your debts and in a fairly short period of time you could be down to a comfortable level. As you pay off those debts, you have more extra income which can be split between payments on the debt next in line and the enjoyment of little rewards.

Psychologically, this serves keep the debtor motivated to continue the process. Seeing actual progress helps one stick with it during a financially challenging time.

But, for all its virtues, the scheme does have one real drawback. It actually requires more time and money in general to pay off all the debts. The reason has something to do with how interest compounds.

If you pay a $1,000 debt, a $2,000 debt, and a $10,000 debt they may all have the same rates of interest. But paying off the smallest amount first actually costs more in total interest paid. Since any balance is charged at the same rate of interest, the higher amount will incur the biggest charge. As a result, over time, you will pay more in total interest charges.

Reversing the order, paying the highest amount first, essentially saves one money in the long run. As you pay down the highest debt first, you are cutting down the amount of interest dollars paid over time.

The trouble is that the latter method, though more cost effective in the long run, is harder for most people to follow. It takes a great deal of discipline to live with that debt burden as you gradually reduce the $10,000 debt.

At most interest rates, the smaller debts will actually get paid off first. But in the meantime you are making high monthly payments. That takes a lot of determination every month.

That determination is the one thing that a lot of people too deep in debt find most difficult to sustain. It’s the factor, often, that led to excessive debt in the first place.

For such people, using the snowball method can be an advantage, even though the larger total amount of money paid out over the life off all the debts combined.