In financial expert Dave Ramsey’s book, The Total Money Makeover he talks about a process called “Debt Snowball” as a tool for becoming financially healthy. Debt Snowball is a debt reduction strategy for reducing non-mortgage debt in a “stacking” or “avalanche” payment method starting with the smallest balance first and cascading down in a snowball effect. While this method is fine for debt reduction, it can harm your CUR (Credit Utilization Ratio, which accounts for 30% of your credit score calculation). The primary benefit of Debt Snowball is psychological, as a 2012 Northwestern Kellogg School of Management study found. Those who tackle small balances first are more likely to eliminate overall debt than trying to pay off high interest or high balances first. By gaining momentum as each debt is paid off the consumer sees real feedback and establishes through that feedback a greater sense of financial discipline, which can only hold them in good stead in the future.
Debt Snowballing looks something like this:
1 List your debts from smallest to largest.
2 Make minimum payments on all your debts except the smallest.
3 Pay as much as possible on your smallest debt.
4 Rinse and repeat until each debt is paid in full.
Here’s how it works:
You have the following four debts:
1 $500 medical bill ($50 payment)
2 $4000 car loan ($125 payment)
3 $7500 credit card ($150 payment
4 $20,000 student loan ($400 payment)
After scouring through your monthly budget, you find that you have an extra $500 of discretionary funds to put toward this method. Therefore:
Snowball Debt, Month 1
Debts 2-4 are paid as planned, while debt 1 is paid off with the extra capital. Now you have 3 debts remaining; the snowball starts downhill.
Snowball Debt Months 2-7
Debts 3-4 are paid as planned, while debt two is paid as follows. Minimum payment $125 plus debt 1 payment $50, plus $500 extra equaling $675. This regimen will pay off debt 2 in just under six months.
Snowball Debt Months 8-11
Pay debt four as planned. Minimum payment $150 plus minimum payment of debt 2 $125, plus minimum payment of debt 1 $50, plus extra $500 equals $825. As debt three was being paid down during the months of snowballing debt 2, debt 3 is paid in full in under three months, and the snowball really grows.
Snowball Debt Months 12-24
Now all minimum payments plus the extra $500 can be applied to the final debt equaling $1225 per month. Again, as debt 4 was being lowered by $400 per month for 11 months, this debt is paid in full in just under 13 months.
Two years and you are completely non-mortgage debt free, including that student loan that you thought was going to hang around your neck like an albatross for a decade.
As Dave Ramsey and Northwestern Kellogg affirm, this is a tremendous psychological victory that will have lasting effects on your financial health for many, many years to come as the discipline has now become innate rather than mustered with great exertion. Certainly, well worth the few extra dollars of interest that one might have incurred using this method. And as far as your CUR, it took a small hit for a few months but rebounded quickly as your reoccurring accounts (credit cards) reached a sub 30% level.
The real benefits of Debt Snowball aren’t in the numbers but in behavior modification. Once the non-reoccurring debt is eliminated the immutable feeling of control and discipline can be applied to future financial endeavors, like a house, or a better house, or a mortgage-free house. And Sallie Mae has to go live somewhere else now.