Spending down debt: The snowball effect
Filed under: Banks, Credit, Debt
This repost is part of our series on strategies you can adopt to free yourself from burdensome debt.
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.
After reading this post, one of my readers, Theresa Bolton-Lynch, contacted me about a money management tool that helps you pay down your debt even faster - including your mortgage. At first it sounded too good to be true. But, after take a closer look at it, I've named it the snow ball effect on steroids.
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)
3-13-2008 @ 8:51AM
Chuck Wolfinbarger said...
The snowball effect for paying down your debt has been used for years by Dave Ramsey i his seminars and in Finacial Peace University. So give him credit for it.
Thanks
Chuck
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3-13-2008 @ 8:48AM
Lita Epstein said...
Sorry, I didn't learn it from him, but if he is the inventor of it he deserves the credit. Thanks for letting me now.
Lita
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3-13-2008 @ 8:52AM
Lita Epstein said...
Chuck,
I do like to give credit when credit is due, but it appears that while Dave Ramsey is teaching it and making it more popular he is not the one that invented it:
http://en.wikipedia.org/wiki/Debt-snowball_method
Lita
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3-13-2008 @ 9:04AM
PMarie said...
When I got out of debt, this is exactly the plan I came up with to do it -- without having read or heard a thing about it. It just seemed to make the most sense to me at the time. So I don't doubt that Dave Ramsey came up with it and has been teaching it, but I do doubt that he was the first to do so.
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3-13-2008 @ 9:33AM
Tina said...
I don't really care who came up with it first. The only thing I care about is getting the correct information and getting my debt paid off. My thanks to any and everyone whom made it easy for me to access the information.
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3-13-2008 @ 9:48AM
Lnze said...
Yeah but what if I enough money to pay off one of my lower interest credit card? Should I get the card paid off or put all that money towards the highest interest credit card to save on interest fees?
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3-13-2008 @ 9:53AM
Lita Epstein said...
Lnze,
You're better off paying on the higher interest rate card. You may even want to transfer some of the debt from the higher interest card to the lower interest card.
The faster you get rid of that higher interest rate card the better.
Lita
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3-13-2008 @ 11:23AM
John said...
Another way that can be used to pay down faster is something I devised called "lower your interest rate". You simply multiply the amount of interest on your current bill by a number. For example: Your interest rate on your credit card right now is 29% and you wish it was lower. The current interest charged on your statement is $20. Mutiplying $20 by 5 would equal a payment of $100. Making this payment would result in $20 going to interest and $80 to the balance. You do the calculation again each month. You will discover that the interest charged is lower each month, your balance is being paid off quicker, your payments are becoming lower using this 5 factor, and you most likely are paying much more than the minimum due. After six months you may get an automatic credit increase which will improve your percent of debt to card limit ratio and be in a position of having the credit card company lower your interest rate based on the way you have handled the account! The result is that at the end of 12 months, regardless of what your balance is, you have paid 25% simple interest. ($80 X 25% =$20) Obviously, a higher factor would result in a lower annual interest rate. Realize also that making the typical minimum payment due at 29% interest means that most of your money goes to interest. The effect of that, when you compare the interest paid to the principal paid, is that on an annual basis the, simple interest rate is outrageous!
3-13-2008 @ 10:02AM
Mike said...
The way I understand your article, you describe the debt snowball as paying off the higher interest rate credit cards first. I believe the debt snowball has to do with arranging your debts from lowest balance to highest balance and paying off the lowest balances first. It has nothing to do with interest rate. The example in your article works because the higher interest rate is also the one with the lower balance.
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3-13-2008 @ 10:15AM
Lita Epstein said...
Mike,
Hopefully most people do have the lowest balance on their highest rate card. If not, and they have a lower rate card with a low balance, then they should transfer as much of the debt off the higher rate card as they can to the lower rate card.
Same concept. Pay off and get rid of that highest rate card first.
Lita
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3-13-2008 @ 10:13AM
Elizabeth B said...
You mentioned paying the mimimun on the high interest cards first and so on & so on. That's good info. Thanks
Now I am speaking about regular payment of your credit card bills.
I find when I pay my bills,I will ALWAYS pay more than the minimun plus the amount of interest that I was charged that billing period, For Example:
If the amount owed for this month's balance is: $2,000 ( $30.00 of it being the interest fee).
Mimimun due is $20.00.
I want $100 to go toward the actual dept this month so, I send in $130 as payment now ( no purchases made )so, the next month I see a the balance going down much faster because, If I had only paid the mimimun of $20, That would have only paid part of the interest fee that was charged on that month's bill and remember , the next bill you get will have another 15%interest fee ,so if you stick to just paying the low Minimum fees due, you are only dealing with paying on the monthly interest fees.
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3-13-2008 @ 10:15AM
Lnze said...
What if you can't transfer any balances?
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3-13-2008 @ 1:00PM
Melanie said...
Well, I've seen this technique from Dave Ramsey and other resources and it works. It's rather comforting that I'm not the only one in the debt boat.. as much as it sucks. We'll all get out eventually :)
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3-13-2008 @ 1:53PM
Mandy said...
Yes, of course pay off the credit cards with the highest interest rates first...learn how to make your $ work for you and in turn keep as much of it for yourself as possible...elimination of the middle man! For me the hardest step was to stop using the credit cards and the only thing that worked for me was to just SHRED THEM ALL! Just something you may want to keep in mind...I did keep one for car rentals and hotels, etc...Just a tip.
M
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3-13-2008 @ 9:35PM
Josey said...
I understand your reasoning for paying off higher interest rate loans first. But those are generally your largest $ amount loans. I would think to keep people motivated, if you knocked out the smallest dollar amounts first then applied that payment to the next smallest and so on. People would realize that they are making headway on thier debt reduction and want to stay on course. Doing it largest to smallest may cause people to give up too soon. This is just my opinon. I'll be completly debt free July '08. I worked my debt reduction smallest to largest. Josey
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3-14-2008 @ 8:48AM
Souette said...
Dave Ramsey is THE MAN! Following this plan for less than 5 years for the price of a book and listening to his daily radio show....
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3-14-2008 @ 8:49AM
Souettelee said...
Dave Ramsey is THE MAN!! In less than 5 years of following his plan for the price of a book and listening to his daily radio show out of Nashville....WE ARE DEBT FREE! My husband I were in our late 40's and when we got out of debt. No house payment, no car payments, no student loans, no credit card debt! It's like winning the lottery. Our paychecks just snowball now. In fact, we just had our house remodeled and paid CASH. I go on 4-5 vacations a year and pay CASH. My daugghter gets to stay at home with her children while her husband in in Iraq...bescause they have NO DEBT. She learned it from us and Dave Ramsey. So now, our grandchildren are reaping the benefits of a debt-free life. I'm telling you people....living debt-free without being a slave to the lender is SWEET! Thanks Dave!!
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3-14-2008 @ 8:59AM
Lita Epstein said...
Souettelee,
Glad to hear you've had so much success following the snowball effect method of debt payoff. While it's true Dave Ramsey has done a great job of promoting this debt payoff strategy, it's been around a lot longer then him.
LIta
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3-31-2008 @ 11:29AM
Brian said...
One would expect that the results of such due dilegence would be at it's greatest point if you achieved the following: No mortgage, house paid for. No auto loans, vehicles paid for. No CC card debt. Substantial balance in a 401k plus a pension plan. Here's the funny part. If you had great credit prior to achieving this goal, your score will go DOWN! How's that for laughers!
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3-31-2008 @ 11:32AM
Lita Epstein said...
Brian,
I don't know why you think your score would go down. The fact that you paid off debt helps your score. Your credit history will look good to any creditor if wanted a loan in the future.
The only thing that could hurt you would be if you closed all your credit cards and then lost some good credit history. But, just because you pay off a card doesn't mean that cards is removed from the credit report. Leave some older cards open and your credit history should look great.
Lita
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