At Rebel Finance, we religiously believe that debt is good, provided that it is used to acquire high quality assets that deliver a stream of cash flows in excess of the cost of servicing the debt. At the same time, we understand that at times, through necessity or moments of weakness, we overextend ourselves financially and enter into the deep, dark and murky world of expensive and unproductive debt. If you find yourself in this position, we propose using the snowball method of paying it down. Rebel Finance did not invent this strategy, but (for what it is worth), we fully endorse it.
So How does it Work? The strategy assumes that your debt is not consolidated – which means that you owe money to more than one party – more than one bank credit card, a few store cards and possibly even a loan from Shady Larry from around the corner.
Point 1: Start with the Smallest Debt First
This goes back to the law of the jungle. Predators focus their efforts on separating the weakest member of the herd. You are this predator and the weakest is that debt of a couple of hundred dollars you owe on your Amazon credit card for a village of garden gnomes you bought after a drinking game with your mates.
Once the smallest debt is paid off, one proceeds to the next larger debt, and so forth, proceeding to the largest ones last. This method is sometimes contrasted with the debt stacking method, also called the "debt avalanche method", where one pays off accounts on the highest interest rate first.
Point 2: Why are we not paying off the most expensive debt?
This strategy wants to keep you motivated so that you can build momentum in your debt liberation method. It may be that your largest debt is also your most expensive. Let’s assume you go after this debt like Edmund Hillary went after Everest. If you are not in good financial shape, by the time you reach the base camp, you are going to be suffering from altitude sickness and crying for your mother. So instead of going after Everest, lets start off with Kilimanjaro and then work our way gradually up to the Himalayas.
The basic steps in the debt snowball method are as follows:
Step 1: List all debts in ascending order from smallest balance to largest.
This is the method's most distinctive feature, in that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the debt with the higher interest rate would be moved above in the list.
Step 2: Commit to pay the minimum payment on every debt.
Determine how much extra can be applied towards the smallest debt.
Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off. Note that some lenders (mortgage lenders, car companies) will apply extra amounts towards the next payment; in order for the method to work the lenders need to be contacted and told that extra payments are to go directly toward principal reduction. Credit cards usually apply the whole payment during the current cycle.
Step 3: Once a Debt is Paid in Full....
....add the old minimum payment (plus any extra amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new sum to repaying the second smallest debt.
Step 4: Repeat until all debts are paid in full.
In theory, by the time the final debts are reached, the extra amount paid toward the larger debts will grow quickly, similar to a snowball rolling downhill gathering more snow, hence the name.
Example (taken from Wikipedia)
An example of the debt-snowball method in action is shown below. In a real payoff scenario, the different interest rates on debts will affect payoff times and might make the debt-snowball method less efficient than other plans. However, for the sake of illustrating the method, the example ignores accruing interest.
Assume you owe the following
Credit Card A - $250 balance - $25/month minimum
Credit Card B - $500 balance - $26/month minimum
Car payment - $2500 balance - $150/month minimum
Loan - $5000 balance - $200/month minimum
Assume you have an additional $100/month which can be devoted to repayment of debt.
First two months - under the debt-snowball method, payments would be made to the blood sucking creditors as follows:
Credit Card A - $125 ($25/month minimum + $100 additional available)
Credit Card B - $26/month minimum
Car payment - $150/month minimum
Loan - $200/month minimum
Third month balance (presuming the person has not added to the balances, which would defeat the purpose of debt reduction) - Credit Card A would have been paid in full, and the remaining balances as follows:
Credit Card B - $448
Car payment - $2200
Loan - $4600
Third month payments - the person would then take the $125 previously used to pay off Credit Card A and apply it as additional payment to the Credit Card B balance, which would make payments for the next three months as follows:
Credit Card B - $151 ($26/month minimum + $125 additional available)
Car Payment - $150/month minimum
Loan - $200/month minimum
Three more months (six total) - Credit Card B would be paid in full (the final payment would be $146), and the remaining balances would be as follows:
Car Payment - $1750
Loan - $4000
Then the person would take the $151 previously used to pay off Credit Cards A & B and apply it as additional payment to the car loan balance, which would make payments as follows:
Car Payment - $301 ($150/month minimum + $151 additional available)
Loan - $200/month minimum
It would take six months to pay the car loan (the final payment being $240), whereupon the person would then make payments of $501/month toward the loan (which would have a $2800 balance) for six months (with the last payment at $234). Thus in 17 months the person has repaid four loans, with two of them being paid in five months and three within one year.