The debt snowball, made popular by Dave Ramsey, is a method that allows you to reduce debt by tackling the small balances first. Getting out of debt is one of the top financial goals for many people.
Possibly the most dangerous financial hazard facing consumers today is mounting debt. The crisis of debt has become so significant that the average U.S. family carries about $8,000 in credit card debt alone, and roughly 43% of Americans spend more than they earn each year. That is no trivial statistic. The revolving debt that so many consumers are under has no end date, meaning, for most of us, our debt will last forever.
How to Pay Off Debt
While too many consumers turn to somewhat risky solutions such as consolidation loans or debt settlement companies, a concept for debt management called the 'debt snowball' is becoming more popular. This is where the smaller balances are paid off first, followed by the larger balances. Using a debt snowball to get out of debt is more than just a trendy name, it's actually a way to pay down debts systematically, and it has a motivating factor built in. As you pay down smaller debts, you see success, and it motivates you to stick to the plan.
How the Debt Snowball Works
Here's how the debt snowball works; as an example, let's say that you have five current debt balances, one of which is $100, another which is $500, two which are $800 and one whopper with a current balance of $4,000. Prior to starting this process, it is best, if at all possible, to be caught up and current for all of the monthly payments. This process of listing the debts in ascending order is important, as we will see in just a moment. It's also of critical importance not to add any new debt while we undertake this process.
The step by step process to get out of debt is to start by paying only the minimums on all of the debts with the exception of the smallest one. In our example, let's say that the smallest debt, our $100 balance, has a monthly payment of $10. Now comes the hard part, which is determining how much more money you can afford to add to the monthly payment for the smallest balance. The best choice would be to double it, to $20, or more if possible. However, any amount will help. Paying more than the minimum will reduce the bill quickly. For our purposes, let's assume that we are paying double, so there is an extra $10 going towards the balance every month.
This will mean that the balance on this will be paid faster, probably in six months or less, even at this low payment. Here's where the beauty of the debt snowball kicks in and really starts to help someone get out of debt: by taking the payment amount, in this case, $20, that was going towards the smallest debt, and applying it to the second smallest debt, we are now paying down that debt faster as well.
If the second payment, with a balance of $500, had a minimum payment of $50, now we are paying an extra $20 per month. Assuming that $10 of the payment is only going toward finance charges, that still means $60 a month directly applied to the debt. That means even a $500 balance will be completely paid off in about 8 months. So now, we've paid off two of our debts in just 14 months.
Here's where the snowball picks up speed. We can repeat the process on the two $800 debts. Going with the same math, we apply the extra $70 to one of the balances, then the other, the first debt is paid in six months, and then the second is paid off in less than four months, and we now have a total of $205 each month that can be applied to the large $4,000 balance.
Just to make this simple, let's say that the payment on the $4,000 is $200 a month already, with $100 disappearing forever into financing charges. So we add our $205 to the minimum payment that’s going toward principal, and the entire balance of $4,000 can still be paid off in just over a year even with a high interest rate.
So, let's sum it up. We paid off all of our debts except for the large one in 24 months, and then it took about a year to pay off the last big bill. That’s just three years total to pay off over $6,000 in debt by doing nothing more than paying the minimum on all debts except for adding $20 extra on the smallest at first. While three years is not an instant fix, it's incredibly short when compared with payments that literally last forever if you just continue to make the minimum payments on all debts. But you know what the best part is? After all the debt is paid off you suddenly have nearly $600 extra in your pocket each month! That can go a long way in creating an emergency fund, saving for retirement, or put aside for a college education.