Snowball Debt Reduction - Myth or Magic?

[jeffrey]

By Scott Bilker

David Sheepsley has two credit cards with balances. Card A has a balance of $8,000 at 19.8% and minimum payments of $160 per month. Card B has a balance of $6,000 at 5.9% with minimum payments of $120 per month. David has a total of $400 per month to use for repaying his credit cards. What's the better plan for David?

1) Pay the most money possible per month to the lowest-balance card (B) first and make minimum payments to the highest-balance card (A) until the lower-balance card (B) is paid off. Then send the entire payment of $400 to Card A until that debt-repayment is completed.

2) Do the reverse. Pay the most money possible per month to Card A and make minimum payments to Card B until Card A is paid off. Then send the entire payment of $400 to Card B until that debt-repayment is completed.




Solution

Paying the lowest-balance first is sometimes called a "Debt Snowball." The problem is that you're rolling the snowball uphill! Here is the quote directly from those who propose this foolish plan, "DEBT SNOWBALL: List your debts in descending order with the smallest payoff or balance first. Do not be concerned with interest rates or terms..."

Many so-called "experts" suggest this ridiculous plan for paying the lowest-balance card off first for psychological reasons, claiming it gives you quicker feedback and allows you to be more likely to stick to the plan."

That strategy is simply wrong! That is, unless you like paying extra money to your creditors.

Here's why:

Debt Snowball Plan: Pay The Lowest Balance First

Card A: $8,000 at 19.8% at $160 per month Card B: $6,000 at 5.9% at $240 per month Total payments equal $400 per month

Card B is paid off in 26.74 months. At that point in time, Card A has a balance of $7,068 to which we start applying payments of $400.

Card A is paid off in another 21.06 months.

Total payoff time is 26.74+21.06=47.80 month

Total payoff cost=47.80 x $400=$19,120

That's $19,120 out-of-pocket cost for the Debt Snowball.

Pay The Highest Interest Rate First

Card A: $8,000 at 19.8% at $280 per month Card B: $6,000 at 5.9% at $120 per month Total payments equal $400 per month

Card A is paid off in 38.96 months. At that point in time Card B has a balance of $2,124 to which we start applying payments of $400.

Card B is paid off in another 5.39 months.

Total payoff time is 38.96+5.39=44.35 months

Total payoff cost=44.35 x $400=$17,740

That's $17,740 out-of-pocket cost paying the highest interest card first.

Conclusion

"Debt Snowball" costs $19,120 "Pay highest rates first" costs $17,740

Additional cost for the Debt Snowball is $19,120-$17,740=$1,380 (because it takes over three months longer to repay the debt using this method).

That's $1,380 more to follow that "expert" advice of paying the lowest balance first. Don't do it! Pay the highest interest rate cards first, no matter their balance! That's being DebtSmart!

If anyone needs psychological reassurance, they'd still be better off paying the highest rates back first because they would have and extra $1,380 to spend on a psychologist!

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Scott Bilker is the founder of DebtSmart.com and the author of Talk Your Way Out of Credit Card Debt, Credit Card and Debt Management, and How to be more Credit Card and Debt Smart.

[Ima saver]

In this case, it makes sense because the two balances are close. In Dave Ramsey's book, he talks about doing it the other way, but he is assuming that you have several debts and maybe one is only about $300. In that case you can pay it off quickly then take the entire amount to apply to the bigger debt.

[terry1156]

Originally Posted by Ima saver

In this case, it makes sense because the two balances are close. In Dave Ramsey's book, he talks about doing it the other way, but he is assuming that you have several debts and maybe one is only about $300. In that case you can pay it off quickly then take the entire amount to apply to the bigger debt.

Nope. Do the numbers. It ALWAYS is better to pay off the highest interest first. Dave Ramsey is just plain wrong on this point and why you should even take these "finincial experts" with a grain of salt.

[SnoopyCool]

Dave talks about the emotional high of paying off a debt and moving on to the next one (on his website) as being the reason why you should pay smaller balances first. I believe he even refers to a study on this. I'm not sure I agree (I like paying on the highest balances more first), but I bet that works for a lot of people!

[PrincessPerky]

Whatever works comes to mind, might not be the lowest cost way, but the point is to stick to it. Though for me I am into the biggest interest first too. (course I only have a house% and a CC %, and a car 0%, so lowest balance is lowest interest .)

[Ima saver]

Yes, I think Dave means that it feels so good to get the small debt paid off first, that you will feel challanged to come up with as much money as you can to throw at the small debt and get it paid off.

[PrincessPerky]

I was thinking more, the 'Ill never get this done'. kids say that all the time but if you break it down to small parts (pick up the cars, look up 5 vocabulary words before lunch, ect.) they manage to get it all done eventually. Grown ups are often just tall kids with no parents to break stuff down. we need small attainable goals.

but like I said, it is cheaper to pay highest interest first. Maybe a made up goal?

[Ima saver]

So I am assuming that you are trying to pay more on your credit card cause that has the hightest interest rate, correct? And it is probably the lowest balance of the 3 debts.

[PrincessPerky]

in my case they are the same, lowest balance is lowest interest, but it isn't always so, and if I want to get tecnical the lowest balance is misc medical stuff with no interest, and I am paying that tonight, but I would feel bad not paying.

[StressLess]

Why not see what will bring your FICO score up the quickest, so you start getting 0% offers?

If the balance on Card X is very close to the credit limit, and Card Z's balance is already below 50% of the credit limit, it makes sense to pay down X as quickly as possible. From what I've read, it's more advantageous to have two cards at 50% utilization than to have one at 90% at the other at 10%.

Also, if your FICO score is being hit by having too many open accounts, you want to pay off the newer ones and then close them, rather than closing ones you've had longer. Your FICO score is helped by having accounts with an older average age.

Once the 0% balance transfer offers start coming in, you can really start to make headway.

[Ima saver]

I am sure you are right, stressless.

[jmjj215]

I have to laugh at the author's pretty high-and-mighty talk though. Dave Ramsey has successfully helped navigate hundreds of thousands of people out of debt. He admits math is not the reason he suggests it. So he's not giving "wrong" advice. He's giving "different" advice based on counseling thousands of people every day. I don't mind if people say they don't like his strategy, but to say it's "wrong" when he himself admits it's not the math, is pretty short-sighted.

[byusteeler]

I think in 90% of the cases the highest interest debt should be paid 1st. This is particularly true in the scenario given as there is such a vast difference in interest rates. There are some cases where paying lowest balance may be desirable. For instance, if the difference in interest rate is only a small amount like 5.9% on the larger balance versus 6.9% on the smaller balance and the balance of the smaller can be paid quickly it may be worth the $5-10 for the emotional lift especially if you are the type of person who is easily discouraged. Or in a case where monthly outgo must be reduced to stay afloat (Layoff or medical cost or some other emergency.) But in most cases I have to agree with Scott Bilker get rid of the high interest debt first.

Someone (I don't remember who) once said of Interest " Them that understand it, earn it. Them that don't, pay it!"

[Ima saver]

Have any of you tried the snowball debt reduction method?

[lillyb]

What is it Dave Ramsey calls it, a 'quick fix', right? You get so inspired paying of that first small one that it keeps you motivated and seeing that it does work. Like dieting. If you diet for a month and see no weight loss then you usually get discouraged and quit dieting. Same with paying stuff off. If you start with your highest interest and that one happens to be your highest debt then it stands to reason that you could possibly the type to get discouraged easier, cause it takes so long to get that first one done.

I'm going with Dave Ramsey on this one. Gonna pay off the smallest to largest, regardless of interst.

[lukkyb22]

Largest % first, unless you have teeny tiny ones and feel you aren't disciplined enough to stay the course. If you are paying down all big ones, and you are watching it chip away on a regular basis, you will be motivated. By the way, if anyone gets a tax return, they need to alter their W4 and increase their dependents. Then they can take that extra $$ in their paycheck and use it to pay down debt instead of giving it to Uncle Sam interest free for a year. But congratulations to everyone beginning the climb out of the hole!

[MarshallMiddle]

Although it may be tempting to pay off the smaller debts first for psychological victory, it will definately cost you in the long run. Pay off the highest interest rate first, then work you way down. Another option would be to consolidate your debt, if you could a loan with a decent interest rate.

[myself]

Originally Posted by Ima saver

Have any of you tried the snowball debt reduction method?

We did at one point in our life. We had consumer debt that we paid mostly minimum payments on, to save for 20% downpayment on our house.
After we got the house, we worked the debt snowball to get all of it paid off. However we used both methods.

We used the payoff lowest principle first method until a couple of the bills were gone, and then switched to the higher interest rate second for the remainder.

Now, the only reason we borrow on the CCs is to use the balance transfer into checking at a low rate, and transfer that amount into savings at a higher rate. I think we made $1,050 last year using this technique (which included paying any minimal interest on the cards, balance transfer fees, etc.

[Squantum]

I feel like the 'debt snowball method' may be best suited for consumer debt (credit cards and cars primarily).

What about this: say that somebody has a 6.25% mortgage for $300,000, a new one with basically 30 years to go, and a 3.125% student loan of $10,000 with 15 years left. Now, we are not talking about credit cards; we are talking about fixed-term debt. One debt interest rate is 2x what the other is, but one debt is also 30 times higher. With aggressive payments, that $10,000 student loan could be paid off a lot quicker than the actual term. But the higher interest rate debt -- the mortgage -- has a principal amount that is so much higher that it would take many more years to pay off than the student loan, even with putting extra money toward that mortgage...

[Aleta]

We snowballed ours and I felt like it was more doable going from the smallest to the largest. My reasoning behind it was because when you have a smaller debt to get rid of; you can think of faster and easier ways to pay it off. Let's say that you have a debt balance of $200. and you are paying a minumum of $20. on it; all kinds of ideas start popping up to get rid of it. It's like eating an elephant one bite at a time. You might start thinking of how you can cut down your grocery bill to start throwing money at that debt. You might consider going out to dinner 1 less time, letting another week or two go before cutting your hair, opting out of that manicure that you can do yourself, sell aluminum accululating in your house, have a garage sale, and the list goes on. When you owe a large sum of money, it's harder to see the effect of what you are doing. While you were paying off that small debt, you were also paying on the rest and reducing them so by the time the one is paid off, number 2 is smaller also and you can use the first payment plus the present one (#2) to pay it off. It's mostly psychological but it keeps you focused.