One of the most popular debt reduction plans is the snowball method. Almost anything you read on reducing debt will include an explanation of the snowball method, whether it uses that name or not. The method involves paying the minimum monthly balance on all debts except for one, to which you consistently pay a set amount over and above the minimum repayment amount. Once this debt is paid off, you apply your repayment amount to the next debt and so on.
Which debt do you make extra repayments on first?
There are several ways to approach the snowball method of debt reduction, but paying off the debt with the highest interest rate first makes the most mathematical sense. Paying off debts in order of interest rate is going to save you the most time and the most money.
I’ve used this method in the past (although I hadn’t heard of the snowball reference then) and it’s a powerful way to chew through debt. Here’s an example of how it works:
- First list all your debts, the balance, the minimum repayment amount and the interest rate.
- Next you need to work out how much you are going to budget for debt reduction over and above your minimum payment amount. In the above example, The minimum repayment total is $711, and I’m going to budget $800 per month for debt reduction or an extra $89.
- Every month, I continue to pay the minimum amount on each debt except for the store card, which has the highest interest rate. On this card the monthly repayment will be $152 – the minimum $63 plus the extra $89.
- Once the store card is paid off, you add the repayment amount to the debt with the next highest interest rate. So my repayments on Credit Card 1 will increase to $185 per month: the minimum $33 plus the $152 from the store card.
- Once each debt is paid off the repayment amounts are added to the minimum repayment on the next debt, so that on the last debt, the personal loan, the repayments that I’ll be making will be $800 per month.
- To make this process easier, automate the repayments. This way, you won’t miss what you can’t see and there is less need to motivate yourself. Set your budget, automate your payments and leave it alone, adjusting the repayment process only when you pay off a debt.
As the repayments compound, the debt reduction accelerates, saving you time and interest. And once you’ve paid off your debts? You can add the $800 to your mortgage repayments or build your savings account.
The other snowball method, made popular by Dave Ramsay, suggests paying off the debt with the smallest balance first. While Dave agrees that you will save more money by paying off the debt with the highest interest first, he argues that reducing debt is just as much about psychology as it is about maths, and that seeing quick results will keep you motivated.
My Take on the Snowball Method
Whether you choose to pay off your debts in order of the highest interest rate, or in order of the smallest balance will depend on how disciplined you are and how much motivation you need. While paying off the debts with the highest interest rate may make more sense, you need to choose a method that you are going to succeed with.
Of course you could combine these two principles. Depending on just how much debt you have, you could pay down one or two of the smallest balances for quick peace of mind, then move on to a debt with a large interest rate, applying the repayments of the prior two and getting the high interest debt knocked down at a quicker rate, keeping the motivation momentum going.
Or as time is important to accumulating interest, it may make more sense to pay down a debt with a larger balance if you only have a small amount on a high interest debt. Use an online calculator and do some calculations and work a method that’s best for you.
Alternatively, it may make more sense to use start building your savings before you have paid off all of your existing debt, to provide a buffer against accumulating fresh debt.
One key element that will impact your success at debt reduction is whether you accumulate more debt along the way. I think the psychological element has more to do with discipline when it comes to spending and less to do with motivation, especially if you automate the process.
What are your thoughts and experiences with the snowball method?
Note: This information is general in nature and not tailored to your situation. It is not financial advice. You should consult a qualified expert and read and consider the Product Disclosure Statement of any financial product before deciding on a course of action.