One of the best known debt reduction strategies is the debt-snowball method where you pay off your smaller debts as soon as possible, while paying the minimum allowable amount on the larger debts. Once the smallest debt is paid off you move onto the next smallest, reducing the total number of debts and building momentum as you proceed.
This formula for paying off debts has a number of proponents including the talk financial guru Dave Ramsey. It has been successful for many people because you feel like you are accomplishing a lot as the total number of debt sources reduces quickly. As you pay off each debt source you feel a sense of accomplishment which is meant to induce a snowballing effect where you become excited about paying off your debts and you see the results on a regular basis.
It also has the advantage of reducing complex debt positions into a simple solution – pay off the smallest debt, then move on to the next one. This can also reduce the risk that you incur late fees because you have less debt repayments to juggle. That can help preserve your credit rating.
The first step to implementing this strategy is to sit down and write out all of the debt sources that you have. Order those debts from smallest to largest, based on the total amount owing, not the interest rate or repayment amounts.
If two debts have pretty much the same amount owning, look at the interest rate payable and pay the debt with the highest interest rate first.
Now list the minimum amount due on each debt, you will need to make all of those payments every month – that is the absolute minimum due. Then look at the smallest debt in the pile, how much more above the minimum payment can you afford? The goal is to repay that smallest debt as quickly as you can.
You will need to make sure that the debtor understands that extra repayments should be used to lower the principle and are not simply an advance on the next monthly repayment. Most credit cards use whatever you pay in addition to the monthly minimum to pay off the principle.
Once that smallest debt is paid off, start paying the total minimum payment you were paying on that debt + the additional amount you could afford onto the next smallest debt.
So for example if your smallest debt was a store card that had a $500 debt and a minimum repayment of $50, you may have paid it off by $100 a month. Once you have paid it off, take that entire $100 per month you were repaying on it and use it on your next smallest debt.
The next smallest debt may have been a credit $2000 card with a minimum repayment of $25. Now you are repaying it at a rate of $125 per month. As you pay off each debt the level of repayments rapidly snowballs, hence the name.
Many people have great success using this method because you are receiving positive feedback on a regular basis as the smaller debts are paid off.
Some debts shouldn’t be including in a debt-snowball, like your mortgage. You mortgage is a long term debt that should be paid off in an affordable fashion for a number of years. The debt-snowball reduction method is fantastic for reducing credit card debt, store card debts, overdue store accounts and many more sources of debt.
There are some criticisms of the debt-snowball method, particularly around the fact that it doesn’t take into account interest rates on debt sources. Some financial experts suggest that for many people, the cost of interest payments on larger debts is much greater than any benefit from paying off small debts.
The issue of making contributions to an emergency fund or for a retirement fund is also an issue with this method. Some financial analysts suggest that contributions to a retirement fund or emergency fund should be halted while using the method, so you pay off debts as quickly as possible. Others suggest that building a retirement next egg should continue throughout your entire life regardless of circumstances, and that not having an emergency fund is a great risk.
The difficultly of building an emergency fund is that doing so does not have the same positive feedback as paying off small debts.
One of the main criticisms of this method is that people who pay off high interest credit cards first may pay down their debts faster in the long run. However that approach only works for people who have financial discipline and don’t require the positive feedback of completely removing debt sources. The proponents of the debt-snowball method suggest that the psychological benefits of the method keep people on the right track and modifies their behavior.
Another criticism of the method is that it only works for people who have more than enough money to pay the minimum payments on all of their debts. For people who are unable to do that, the method is worthless and they will need to seek other means of reducing their debt including debt negotiation, debt consolidation or even bankruptcy.
Overall it is a very simple method that has worked for many people over the years. If your debts are still at a level where you can make minimum payments and afford a little bit more, it could be a great way to reduce your debt burden!