Debt snowball method
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 Dave Ramsey.
Method
The basic steps in the debt snowball are:
- List all debts in ascending order from smallest balance to largest.
- 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 snowball will be "rolling" quickly as it has picked up a lot of financial mass. Hence, larger debts will be paid off faster.
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. Ramsey teaches 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, the Ramsey plan pays off home mortgages in "Baby Step 6", along with any other debt which is equal to or greater than half of one's annual take-home pay.
Variations
Some financial advisors suggest a variation of this strategy in which the debts are listed in descending order according to the interest rate that is charged. The idea is to reduce the debts that are growing the fastest in order to minimize the total amount of interest paid. Others recommend paying the debts that cause the most worry or stress.
Ultimately, the best choice depends on the situation and outlook of the debtor. Those who are unsure of their ability to stick with the plan may want to pay the smallest debt first, because the thrill of eliminating an entire balance sooner may encourage them to continue. If an interest-free loan from a sibling or parent has gone unpaid for so long that it threatens to destroy a relationship, it would be a logical first choice for repayment.