Financial rockstar Dave Ramsey is most famous for the concept of ‘debt snowballing’ – a debt reduction strategy he detains in The Total Money Makeover. Thousands of people have used Dave’s strategy to reduce their liabilities, but it is important to understand both the benefits and limitations of the snowball before deciding if it is right for you
What is Debt Snowballing
The debt snowball method involves making minimum repayments on all debts and focusing any extra repayments towards the debt with the lowest balance. Once this debt is eliminated, focus shifts to making extra repayments on the debt with the second lowest balance – including the funds previously used to pay the previously eliminated liability. This process continues, eliminating liabilities in order of value until finally the highest balance debt is repaid.
John has $100 per month left over after paying his living expenses and the minimum repayment on his three outstanding debts:
- A personal loan of $2,000 with a minimum repayment of $50 per month
- A Credit card balance of $10,000 with a minimum repayment of $300 per month
- A mortgage of $300,000 with a minimum repayment of $1,000 per month
Using debt snowballing, John will pay the minimum repayments on his card and mortgage, contributing the extra $100 towards his personal loan (on top of the $50 minimum). John continues to contribute this $150/m towards the personal loan each month until the entire balance is repaid. John now has $150/m spare, which he can contribute towards his credit card while maintaining minimum repayments on the mortgage. By the time the card is paid out, John will have $450/m spare to contribute to his mortgage ($100 surplus + $50 from the personal loan and $300 from the card).
Benefits of the debt snowball method
The benefit of the debt snowball lies in the associated psychological benefits. By repaying smaller debts first, the impact of extra repayments are more noticeable. As each debt is repaid and one less creditor is owed money, the amount of bills requiring repayment each month will reduce sooner than using other methods. These ‘quick wins’ are likely to provide motivation to continue further repayments.
The disadvantage of debt snowballing
Debt snowballing does not factor in the interest rate of each debt. In the example above, the interest rate on John’s credit card may be greater than the interest rate on his personal loan. If this is the case, John would become debt-free quicker by repaying his card first. In doing so, he would minimise his total interest expense but he would not repay any individual balance in full for much longer. John would therefore require greater patience and willpower to continue his extra repayments as their effect would not be as obvious.
Is the debt snowball right for me?
Dave Ramsey’s debt snowball method is suitable for people with multiple debts who lack the motivation or willpower to make extra repayments for an extended period of time. The quick perceived progress caused by eliminating smaller debts provides incentive to continue extra repayments. While debt snowballing is financially inefficient, the associated motivation boost could actually result in more progress due to keeping focused. For those with greater financial discipline, repaying liabilities in order of interest rate makes much greater sense.