Paying Down Debt: Use the snowball effect
Do you want to pay down debt, but aren't sure how to do it? One of the best methods out there is called the snowball effect. This strategy of paying off debt focuses on getting rid of your highest interest rate credit cards first, which makes a lot of sense from a financial planning perspective because you reduce your interest expenses the fastest.
Think of the snowball effect as slowly building up the size of a your snowball then getting the snowball moving faster and faster by pushing it down hill. To use this strategy you start by paying the minimum amount on all but your highest interest credit card. Then use every extra cent you can find to pay the greatest amount you can on your highest interest credit card.
When you get that card paid off then continue paying the minimum amount you were paying on your second highest credit card plus the larger amount you were paying on the highest interest credit card.
Let me show you how this works. Suppose you have three credit cards that you've maxed out. Credit Card A charges 18% interest and has a balance of $1,000. Credit Card B charges 15% interest and has a balance of $2,000 with a minimum payment of $20. Credit Card C charges 12 percent and has a balance of $3,000 with a minimum payment of $35. In addition you have a car loan that charges 6% interest and a payment of $150 and a mortgage with a payment of $1,000.
I'll assume this debtor has a total of $1,500 to pay bills to get the snowball started. To keep this simple I'm not going to calculate interest, but that additional cost will slow down the payoff because balances will not go down as quickly as shown here.
Month one you would use the $1,500 to pay:
Credit Card A $295
Credit Card B $ 20
Credit Card C $ 35
Car Loan $150
Mortgage $1,000
After these payments the balances (not considering interest) would be:
Credit Card A $1,000 - 295 = $705
Credit Card B $2000 - 20 = $1980
Credit Card C $3,000 - 35 = $2,965
Month two you would make the same payments and the balances (not considering interest) would be:
Credit Card A $705 - 295 = $410
Credit Card B $1980- 20 = $1960
Credit Card C $2,965 - 35 = $2,930
Month three you would make the same payments and the balances (not considering interest) would be:
Credit Card A $410 - 295 = $115
Credit Card B $1960- 20 = $1940
Credit Card C $2,930 - 35 = $2,895
Month four you would pay off Credit Card A and any extra toward Credit Card B. Payments (not considering interest) would be:
Credit Card A $115 - Paid off
Credit Card B $200 (extra from Credit Card A after payoff - $180 plus $20)
Credit Card C $35
Car Loan $150
Mortgage $1,000
Month four your balances (not considering interest) would be:
Credit Card A $0
Credit Card B $1960- 200 = $1740
Credit Card C $2,895 - 35 = $35
You can see that in four months you'd already have one credit card paid off. Starting with month five your snowball grows to $315 (the $295 that you used toward Credit Card A plus $20 (the minimum you were paying on Credit Card B)). In about six months Credit Card B would be paid off and then you could grow the snowball again to $350 toward Credit Card C ($315 you were using for Credit Card B plus $35 (the minimum you were paying on Credit Card B)). When Credit Card C is paid off than you can add the $350 to your $150 car payment and get rid of that more quickly. Finally you can use the extra $500 to pay down your mortgage more quickly.
Of course, in order for this to work you must stop charging to your credit cards until you get them paid off. Once all your cards are paid off, if you want to use them and pay them in full each month that makes sense, especially if you have a good rewards programs.
Lita Epstein has written more than 20 books including the "Complete Idiot's Guide to Improving Your Credit Score."
Reader Comments (Page 1 of 2)
2-18-2008 @ 5:53PM
Al said...
You did not account for the usage on the other c/c which will increase your balance and not really pay them off as early as you would think.
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2-18-2008 @ 1:01PM
Lita Epstein said...
Al,
I clearly said all three cards were maxed out. Can't charge on a maxed out card.
I would hope that if someone intends to pay off their credit cards, they don't continue charging on them. If they do then of course they'll never get paid off.
Lita
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2-18-2008 @ 4:17PM
Genesis said...
The best way to pay off your credit card is to send payments on a weekly basis. Of course many people can't afford to do this, but that's what i do. It reduces your debt drastically rather than sending monthly payments.
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2-18-2008 @ 5:09PM
nancy said...
how do you feel about transferring balances with extremely low - or 0% - interest rates, using the checks sent by the cc cos. I am aware of interest rates soaring if you are late or go over...but if there is no additional activity and you use ach automatic transfers for payments this would not happen. In other words, why would I NOT want to pay off one card with a 12.99% rate using a check from another card with a 3% int. rate? please advise
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2-18-2008 @ 5:21PM
Lita Epstein said...
Nancy,
As long as you're going to destroy the higher interest credit card and pay down the 0% interest card as soon as you can, it does make sense to save the money up front. But, check carefully to be sure you know your total fees of the transfer and how long you'll have the 0% interest. Sometimes the interest rate you'll pay after the introductory period is higher than the card your paying off. Be sure in the end you'll really end up saving money.
Lita
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2-19-2008 @ 4:49AM
Theresa said...
Please also note - do destroy if you are trying to refrain from using the card again but Don't close the account if you want to keep your trade lines showing for credit score status- And if you have several cards with low balances and only one or two that are maxed out you may want to spread out the balances to the extent that your debt to available credit ratio is best when debt is under 35% of total available - while you are still trying to pay down the overall debt this will help to boost scores.
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2-23-2008 @ 5:42PM
Dianne Green said...
We tried not using a card and first they lowered our limit and then after 2 mos. they canceled the card. Not what we wantedm but what we got using this system. So what now?
2-19-2008 @ 5:17AM
Lita Epstein said...
Theresa,
The strategy of paying down credit cards for the purpose of improving your credit score is called the round robin strategy and I talk about how it works in this post - http://www.walletpop.com/2008/02/18/the-round-robin-way-to-pay-down-debt-and-improve-your-credit-sco/.
Lita
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2-23-2008 @ 10:47AM
tomhayabusa2002 said...
hi my name is tom can't afford topaid my creditcard what to do help
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2-26-2008 @ 9:34AM
Bill said...
My question re: not closing an account when paid off in full. How do you handle this for companies that charge you an annual fee?
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2-25-2008 @ 8:00PM
Lita Epstein said...
Bill,
I don't recommend keeping accounts open that charge you an annual few.
Lita
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3-05-2008 @ 5:00AM
Shell said...
What are the pros and cons of using a credit counselor?
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3-05-2008 @ 5:09AM
Lita Epstein said...
Shell,
Credit counseling can be very helpful, but be certain you work with a nonprofit agency certified by the National Foundation for Credit Counselors (http://www.nfcc.org/). You can find a link on their website to locate a counselor near you. Many credit counselors advertise they are non profit, but end up charging lots of fees and giving little true debt management education.
Lita
3-05-2008 @ 5:03AM
otrpu said...
There are exceptions to always paying down highest rate cards first. When you can clear a couple lower debt, lower interest cards first you can free up cash flow to aggresively attack the remaining higher rate card. My wifey took your advice, took an inheritance and throwed it at the high rate card. Made no difference at all. I'm still fighting like heck to make all the payments. Would have been much better off to have her pay off a couple smaller issues and free up the cash flow. Wish she'd listen to me instead of you.
JMHO
OTRPU
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3-05-2008 @ 5:09AM
Lita Epstein said...
OTRPU,
Can you transfer the remaining balance of the higher interest rate card to the lower interest rate cards that you're nearer to paying off?
Add up the interest you're paying on each of the cards. You will save money by lowering your interest rate on the balances you have.
Lita
3-05-2008 @ 5:20AM
Shell said...
Thanks for the information. Am I better off trying to just pay these off on my own? I am recently unemployed with no prospects and no spare cash.
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3-05-2008 @ 5:24AM
Lita Epstein said...
Shell,
It can't hurt to talk with a credit counselor. You can always decide not to work with him or her.
Lita
Reply
3-07-2008 @ 10:46AM
saul said...
I have two kids in college and took out parent plus student loans [currently totaling $150k @ 8.5% interest and requested forbearnce; I want to refinance mortgage currently @ 5.50% rate and payoff student loans and an other $15K in credit card loans.
What's your advice?
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3-09-2008 @ 4:01AM
Christopher Lyons said...
Christopher Lyons Independent Researcher. tiptopwebsite.com/netspendreferral4216823698
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3-13-2008 @ 9:37PM
Joe B. said...
Lita,
I posted a comment to one of your other articles aasking you to comment on the MOney Merge Account from United First Financial.
I just read your article on the snowball affect and clicked on the link "the snowball affect on steroids" and it took me to a link for a U1st Agent.
You don't need a $3500 software program to accomplish this. I've crunched all of the numbers. Trust me. You are simply taking all of your discretionary income and dumping it on the principal of your mortgage. If you do the same thing yourself, the payoff will be faster than U1st's because there is no interest payment from a Heloc and no cost of $3500 for the software.
The downside of doing this is that you lose the use of your discretionary income because the money is tied up in the equity in your home. To cover yourself, simply take out a home equity line of credit or a personal line of credit that you can tap for emergencies. You should also make sure that you are putting some money away in savings as your rainy day fund as well. Discretionary income in my opinion is defined as income left over after all bills and monthly expenses are paid and deposits are made to your 401K, savings accounts, and other investments. It's important to do both so you don't have to tap the lines of credit in an emergency.
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