I remember back in 2003 my wife and I sold our condo and bought a new home. That was the beginning of my real estate endeavors and I was just starting to focus on becoming financially independent. We were doing well and on our way to paying off all debt, which included a mortgage and a few car loans. That is, until, in 2005 when we borrowed from our HELOC to fund the adoption of our beautiful, brilliant and caring daughter. Gone were our dreams of what it would be like to not have to pay a mortgage or auto loans. It was the best decision our family has ever made, however it was back to the beginning of our debt situation.
Taking a bunch of steps backward into debt had me wondering how far we were pushed back and what was the most efficient way to track, plan and pay down our debt. In my research, I stumbled upon one of Dave Ramsey’s suggested debt reduction methods – the debt snowball strategy.
The Debt Snowball Strategy
Do you remember the cartoons from when you were a kid? Like the one where a snowball started up on a hill and rolled down, picking up more snow, and eventually became a giant snowball of power that plowed into an unsuspecting character. That is the gist of the snowball strategy, it gives momentum to your debt strategy and allows you to smash your debt down. The snowball strategy pays off your lowest debt first (and fast) and provides the momentum for you to apply (roll) more payments to your next debt, by applying the debt payments from the recently paid off debt.
First, the strategy assumes you already have your bills budgeted and you’ve set up your emergency fund.
The strategy is implemented by:
- Listing your debts in order from low to high.
- You then calculate how much minimum payments are for each of your debts.
- Once you calculate your income minus your budgeted bills and minimum debt payments, you now have an approximate number (your initial snowball) you can pay towards your smallest debt. See Caveat at End*: You may not want to put all of this towards debt if you are not 100% comfortable with your emergency fund.
- Once your smallest debt is paid off you repeat by adding the previous minimum debt payment (on the previous loan) plus extra snowball amount and apply that payment amount to your next smallest debt.
For example, let’s assume your debt is:
- $1,000 Visa Credit Card Payment at 12% interest ($100 minimum)
- $5,000 Student Loans at 8% interest ($500 minimum)
- $12,000 Auto Loan at 4% interest ($500 minimum)
- $25,000 Personal Loan at 10% interest ($750 minimum)
In this situation, we need to make minimum monthly payments of $1,850 month, however, we are also willing & able to provide an additional payment (snowball) of $500 month.
- In the first two months, we would be making our minimum payments on all the debt except for the credit card payment, which we would pay $500 a month toward for two months, before it was paid off.
- After two months, the student loan payment would be receiving not only it’s minimum $500 payment but the visa credit card’s previous minimum of $100 plus the snowball of $500, totaling $1,100 for about 3 more months.
- After the student loan was paid off in month 6, our auto loan, which was receiving a measly $500 minimum payment would now be receiving $1,600 per month! That’s $500 minimum for the auto loan, $500 minimum from the student loan that’s been paid, $100 minimum from the credit card payment that’s been paid off and of course our original $500 snowball we are committed to each month.
- After approximately one year, only the personal loan is left, at which time the huge snowball is now making $2,350 payments and after about 8 payments, all of these debts have been paid off.
If we were to do this scenario, starting today, May 18th, we would have all $43,000 of this debt paid off in about 20 months! That $500 snowball also saved us money. We only spent about $3,280 in interest during the period of loan repayment. If we only paid the minimums and snowballed only the payments (not the extra $500 snowball), we would have spent an extra $900 in interest! If we only paid the minimums but didn’t snowball the payments at all, we would be paying them for the entire term of each loan, which vary, but would have been significantly more interest than an extra $900.
Remember, this has all been done by only allocating $500 more per month toward initially paying down debt – the power of the snowball gave us exponential results.
The Debt Avalanche Strategy
My personal favorite is the debt avalanche strategy. The debt avalanche strategy will typically save you more money and pay off your debt quicker. Saving more time and money may motivate you more than paying off your smallest debt first.
The debt avalanche is like the debt snowball. The only difference is that you pay off your highest interest debt first, not your smallest debt.
For example, let’s take the above numbers and reuse them:
- $1,000 Visa Credit Card Payment at 12% interest ($100 minimum)
- $5,000 Student Loans at 8% interest ($500 minimum)
- $12,000 Auto Loan at 4% interest ($500 minimum)
- $25,000 Personal Loan at 10% interest ($750 minimum)
In this case, the order of snowball payments goes from the highest loan interest rate to lowest, which would be 1, 4, 2, and 3.
1. $1,000 Visa Credit Card Payment at 12% interest ($100 minimum)
4. $25,000 Personal Loan at 10% interest ($750 minimum)
2. $5,000 Student Loans at 8% interest ($500 minimum)
3. $12,000 Auto Loan at 4% interest ($500 minimum)
Notice the descending order of interest above. We will now commit to paying the extra payments toward the highest interest payments first.
We start this by repeating the same four step process above, by paying off the highest interest loan (12%) with the loan’s minimum and our $500 extra (snowball) payment and continuing to roll down your debt to the next highest interest rate (10%).
This results in a total interest paid of $2,974, a 9.32% savings over the snowballs $3,280 total interest paid. It doesn’t seem like much, but if you have more debt these savings get compounded over time, meaning you will save more money and even pay off your debt quicker, possibly by months or years sooner.
So, which one should you choose?
There is no right one. According to Dave Ramsey, it’s important to build momentum and see success early on and that’s why the snowball method may be better for some people. It may motivate them to see that small $1,000 loan paid off so they will be motivated to keep up the debt fight and pay off that student loan debt of $5,000. I understand this motivation, although, I’m motivated more by knowing how much I’m saving, as a penny saved is a penny earned, right?
Hands down in every situation, the debt avalanche WILL save you more time and money, but like I tell everyone who wants to lose weight and keep it off there is no ONE diet. In my research, the people that keep off weight have found a diet & exercise routine that motivated them specifically. Similarly, you need to choose a debt reduction strategy that motivates YOU and keeps you on your plan.
Do you get more confidence and excitement about paying off that smaller debt first? If so, choose the snowball method as it may be the driving force you need to continue this path.
Do you get more excited about saving money and paying off all your debt sooner? If so, choose the avalanche method.
Don’t fret, there is no wrong choice. Even if you feel you are wrong after a few months. You can always recalculate and redo your plan and it’s great because, either way, you’ve paid down a portion of your debt.
Other ideas?
Stop Creating More Debt – This goes without saying, but if you are trying to pull yourself out of a hole it doesn’t help to keep digging deeper. You may need to have a family meeting and freeze all your credit cards—literally throw them in water and freeze them in the freezer. By the time you thaw them out it should give you enough time to think if what you are about to buy is a necessity or a luxury item. You must take a hardline approach to committing to not taking on more unnecessary debt unless the debt is an honest performing asset.
Create a Budget – There are many online spreadsheets to create a budget. They should, at the very least, contain listing your income, expenses, figuring out necessities and committing to a percentage or amount in each given area that you agree to stick to.
Lower Your Loan’s Interest Rates – Shop around for various credit card or loan offers to see if you can payoff a significant amount of your debt with a much lower interest rate. Depending on your credit, you may be surprised to find out you can save hundreds of dollars by doing a balance transfer. Just make sure you read the terms and conditions of the balance transfer, there may be hidden fees or time limits that may defeat the purpose of doing the balance transfer. I know Dave Ramsey dislikes credit cards so he may not approve of creating another line of credit!
Borrow Against Your Life Insurance, 401(K) Or Home Equity Line – If you can borrow from your life insurance or home it will typically be at a lower rate than your other high interest loans. You can take the money from these accounts and transfer the balances of your higher loans into your lower interest retirement or HELOC accounts, potentially saving you thousands on interest. As always, contact your CPA before you touch any retirement or insurance account.
If You Don’t Do Any of This, At Least Pay More Than The Minimum – If you do nothing, at least pay a bit more than the minimum. Minimums are designed to have you pay the most, legally, to the bank over the longest period possible. Just paying an extra hundred each month on a large debt can seriously cut down the amount of interest (and time) you have to pay toward that debt.
Recommended Tools: I would recommend this FREE (I have no affiliation with them) debt snowball calculator, available from Vertex 42. You can download the calculator in excel or google sheets.
Caveats & Disclaimers:
- ALL DEBT IS NOT BAD. I often have an internal debate on debt with Dave Ramsey on one shoulder and Robert Kiyosaki on the other. In my humble opinion, all debt is not bad. There is good debt and bad debt but I don’t want to get into that here. Just know that I believe performing assets and some loans, if leveraged correctly, can also aid in getting rid of bad debt. Some don’t even pay off their primary home for a needed interest deduction. This article is mainly talking about loans and credit cards that were used in your life to acquire “things” that did not provide you a monetary return, like a television or a car.
- There are many other debt payoff methods not covered here that may work better for you and your specific situation.
- *Before you commit your entire financial wherewithal to paying down your debt you should have your emergency fund set up and possibly consider any other vital financial goals. Any of these strategies assume you have an emergency fund that is right for your situation.
- I am not a financial advisor so I would suggest you contact a qualified professional before you make any financial changes or commitments.
