Debt Snowball Approach
Debt snowball approach is a popular and a widely used debt payment method among debtors to pay off their loans. It may sound like something from a movie but it is actually quite effective to beome debt free in the fastest time.
Debt Snowball Approach – Understanding the Debt Repayment Method
The debt snowball plan is basically a method that organizes your outstanding debt in such a way that the funds you already have available for paying off debt are carefully and optimally distributed so that it allows you to pay off your debt both cheaply and faster.
This method of debt repayment was popularized by Dave Ramsey, recognized as the financial guru. Although this method is much similar to its brother, debt avalanche approach, which focuses on retiring loans with high interest; what makes it different is that the debt snowball approach lists the debt and pays them off with the smallest payoff or balance first.
The concept behind this approach is that paying off debts with small outstanding balances first gives you quick results and you are most likely to stick with the plan and continue your journey towards being debt free without losing your patience which is usually the case when people opt for debt avalanche.
Advantages and Disadvantages of Debt Snowball Approach
Now that we know what the debt snowball approach is, let us evaluate the pros and cons of this debt reduction strategy:
1. Well, the first main advantage of this strategy is the positive psychological effect. It gives you the immediate feeling of victory.
2. Each small success looks like an achievement which keeps the debtor motivated to stick to the debt reduction plan.
3. It is simple and easy. There is nothing complex about it as you don’t have to indulge yourself in complicated interest rate computations or use tricky financial formulas in order to determine what debts you should settle first.
But like every coin has two sides, similarly, the debt snowball strategy also comes with its own set of disadvantages. Let us go through them to determine whether or not the pros outweigh the cons:
1. The bigger debt payments take up more money because of their compounding interest rate effect. This means paying them last may result in spending more on interest and extending the payment periods for bigger loans.
2. This plan may not be suitable for people with low income and no self-discipline. Typically, this is because, to pay off debts timely and stick with the plan, you’ll have to make sure that you curtail your expenses and control your spending.
Debt Snowball Effect – How does it Work?
As discussed above, this repayment plan focuses on paying small debts first rather than paying large outstanding balances. All extra money each month is devoted to paying off the smallest debt while making only a minimum payment on all of the other remaining debts.
Once the smallest outstanding balance is paid off, the debtor starts to put extra money each month towards the second smallest debt to retire this account. The process continues to where the debtor pays off each debt and retires it from the smallest to largest until all of the debt is paid completely.
In this method, interest rate is not a factor in selecting what debt accounts need to be paid of first; instead debt accounts are arranged with respect to the smallest outstanding balance.
Let us now take a deeper dive to understand this concept better:
Assume you put $1000 every month to retire 3 debt sources. These include:
- Credit card debt of $2000 which has $50 minimum monthly payment
- Auto loan debt of $5,000 which has $300 minimum monthly payment
- Student loan of $30,000 which has $400 minimum monthly payment
Using this method, you spend a total of $750 to pay each account minimum debt payment while you put the remaining $250 towards retiring the credit card debt with the smallest outstanding balance out of all three debt sources. Once you completely pay off your credit card debt, then you will focus on paying off and retiring the second smallest debt payment account the auto loan account. Once it is paid in full, then you will focus on retiring the student loan account.
As you clear your debt and see quick results, you’ll feel more confident and enjoy the victory of settling your debt. Small milestones like these are what keep debtors motivated when they opt for the debt snowball approach to pay off their outstanding balances.
For more information on debt snowball reduction strategy or assistance in choosing the best method according to your financial situation, get in touch with us. Our debt consultants work in your best interest and can help you find and identify the best debt reduction and management strategy according to your financial goals and needs.