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Debt Snowball

Paying off debt balances from the smallest balances first, then subsequently paying off larger debt balances

What is the Debt Snowball Method?

The debt snowball method is a strategy for payments that is used to reduce debt. It involves paying off debt balances from the smallest balances first, then subsequently paying off larger debt balances, with the largest debt balance being paid last. The principle behind the debt snowball method is that the payor gains momentum as debt balances are paid off, which is similar to a “snowballing” effect.

The debt snowball method is in contrast to the debt avalanche method, wherein the debt balances with the highest associated interest rates are paid off first, regardless of the size of the debt balances.

 

Debt Snowball

 

Steps in the Debt Snowball Method

The debt snowball method can be executed in the following steps:

  1. Create a list of all debts, starting with the smallest debt balances and descending towards the largest debt balance. The smaller debt balances should be paid off first under this method, regardless of the interest rate. If two balances are similar, the higher interest rate debt balance should be prioritized.
  2. The minimum payment should be made on each debt to preserve personal credit.
  3. Determine extra free cash flow that can be allocated towards paying off greater than the minimum payments.
  4. Use the extra free cash flow to allocate towards paying off the principal of the smallest debt balance.
  5. Once the first debt balance has been paid off, the minimum payment that would have been allocated towards the first debt should be applied towards the second smallest debt balance. This should increase the debt payments paid towards larger balances over time, which results in the “snowball” effect of paying off debts quicker.
  6. The method should be repeated until all debt balances are fully paid off.

 

Benefits and Drawbacks of the Debt Snowball Method

 

Benefits

  • Paying off smaller balances will be quicker, which may psychologically make paying off debts easier and more fulfilling
  • Larger debts will be less daunting once all smaller debts have already been paid off

 

Drawbacks

  • May end up paying a larger amount of total interest

 

The debt snowball strategy is more effective for personal consumers as the psychological benefit of utilizing the strategy may outweigh the increased interest burden.

The downside is that since the strategy prioritizes paying off the smallest debt balance, regardless of the interest rate associated with the debt, it generally does not minimize interest paid.

As mentioned above, the debt avalanche method prioritizes paying off the debt balances with the highest associated interest rates, which should economically maximize the amount of interest savings. However, human psychology should not be ignored when considering personal loans. Many individuals have large amounts of debt due to their inability to manage their debt from multiple sources.

The debt snowball method simplifies and makes paying off multiple debt balances easier, although it may not be optimal in terms of minimizing interest payments.

 

Practical Example

The debt snowball method is best utilized by personal consumers with multiple debt balances.

Consider a 40-year old person who has accumulated the following debt:

 

Debt Snowball - Sample Table 1

 

In addition, the person has an after-tax monthly income of $6,000 and monthly expenses of $4,500 (including minimum payments on debt balances).

Following the debt snowball method, this person would list out the debt balances as follows:

 

Debt Snowball - Sample Table 2


Therefore, the personal loan would be paid off first, followed by Credit Card A, and continuing towards the Mortgage Loan last.

Next, we can calculate that the after-tax free cash flow that can be allocated towards paying down debt balances.

$6,000 (after-tax income) – $4,500 (expenses) = $1,500 (excess free cash flow)

This $1,500 per month would be used towards paying off the personal loan first. Once that has been paid off, the excess amount can be allocated towards Credit Card A, and so on.

Again, the drawback of utilizing the debt snowball method is that the interest liability is not being minimized. Credit cards generally have very high associated interest rates, and in many cases, it would make more sense to pay them off first.

Furthermore, this method does not consider opportunity costs. As a simple example, if an investment can earn 10%, it may be advantageous to utilize the extra free cash flow to invest and continue making minimum debt payments as long as there is no debt balance with an associated interest rate higher than 10%.

 

More Resources

Thank you for reading CFI’s guide to the Debt Snowball Method. To keep advancing your career, the additional CFI resources below will be useful:

  • Best Personal Finance Software
  • Debt Consolidation
  • Effective Annual Interest Rate
  • Financial Literacy
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