The Debt Snowball: How it works?

On this blog, I often share the things I feel everyone should be aware of in order to better manage their finances. I mostly focus on the tools and techniques that will help you make better and more informed decisions. This article is of a similar nature where I will discuss one of the simplest, yet most effective and popular loan repayment techniques: the debt snowball.

The logic behind this technique is the same as the most effective snowball building technique – you build a small snowball and roll it around in the snow. As it gains momentum, it gains traction and the snowball gathers mass. In this technique, the same principles are applied to money. You start with a small extra amount to pay off your debt. As the debt reduces, the small amount starts getting larger which, in turn, helps you repay the rest of the debt quicker.

Before we dig deeper into the mechanics of the technique, let’s just discuss the prerequisites for this. There are two main compulsory prerequisites. First, the debt snowball technique assumes that you can at least make the minimum payments on all your debts and loans, and still have something left every month. If you do not meet this prerequisite, please consider debt consolidation or refinancing options.

The second prerequisite is the actual willingness to improve your financial position. If you are not committed to the idea of financial freedom, or at least serious about paying off your debt, no technique is going to work. It takes time, effort and discipline to become financially independent and while this technique helps you with the motivation you need, it will only work if you are committed to the idea.

How does Debt Snowball work?

This technique is a proven technique suggested by many financial advisors to help people pay off their loans and other debt. The basic technique works as follows:

  1. Make a list of all the different debts that you owe.
  2. Rearrange the list from smallest to largest amount irrespective of the interest rate.
  3. Start paying only the minimum amount on all the debts.
  4. With the money you have leftover, start paying off the principal amount on the smallest debt first.
  5. Once the smallest debt is paid off, use that extra money to pay off the second smallest debt and so on.
  6. Keep repeating until all the debts are paid off.

The technique is simple yet very effective. It helps you pay off your debts by keeping you motivated. The idea here is to use all the extra money that you have (apart from your emergency fund) and focus it on paying off your smallest debt as soon as possible. Clearing your first debt will give you more spare cash every month in the form of savings from the minimum payment on the paid off debt(s) as well as the interest that you will no longer be paying. This momentum builds from small payments at the start to larger sums of money just like a snowball rolling down a mountain gains size, hence the name of the technique, The debt snowball.

A simple example

Let’s gain a better understanding of how the technique works with an example. Imagine that you have three loans with different interest rates: a car loan, a student loan and two credit card loans:

Loan type Amount Minimum Payment Interest Rate
Car loan $12,000 $170 5%
Student loan $18,000 $260 6%
Credit card 1 $3,000 $90 18%
Credit card 2 $1,200 $45 22%
dept snowball method and how it works
image credit: credible.com

 

The first thing you need to do is to arrange them in the order of smallest to largest.

Loan type Amount Minimum Payment Interest Rate
Credit card 2 $1,200 $45 22%
Credit card 1 $3,000 $90 18%
Car loan $12,000 $170 5%
Student loan $18,000 $260 6%

The next step is to estimate how much you can contribute monthly towards the debt repayment. Let’s suppose, you can consistently spare $800 each month. The first month payments for the credit card 1, car loan and student loan will be the minimum payments for a total of $520 while the remaining $280 of your budget will go fully towards repayment of credit card 2. This will continue until the total balance for credit card 2 is cleared in the 5th month. From then, the car loan and student loan will be on minimum payment while you clear credit card 1. The repayment plan is shown in the table below.

Month Credit Card 2 Credit Card 1 Car Loan Student Loan Total Payments
1-4 $280.00 $90.00 $170.00 $260.00 $800.00
5 $139.27 $230.73 $170.00 $260.00 $800.00
6-12 $370.00 $170.00 $260.00 $800.00
13 $206.52 $333.48 $260.00 $800.00
14-32 $540.00 $260.00 $800.00
33 $424.48 $375.52 $800.00
34-49 $800.00 $800.00
50 $82.40 $82.40

If you stick to the minimum payment, the debt will take a total of 86 months, more than 7 years. The total payments would be a whopping $42,841 on a principal amount of $34,200. This makes the total interest portion of the payments as $8,641 which is about 25.27% of the principal. However, you can see that by using that technique you will be paying off the debt in just over 4 years paying a total of $39,282 making the total interest portion of the payments as $5,082 or 14.86% of the principal.

As you can see that by using the debt snowball technique you can not only get rid of all your debts much quicker than the minimum payment option that your finance provider requires, but also make huge savings. In the example above, the total debt repayment time is reduced from 86 months to 48 months, nearly half of the original. You also pay $5,082 in interest instead of the $8,641 which is $3,559, or 41% saving on the finance cost.

Why it works

Although there are other techniques capable of making greater savings while being able to further reduce the repayment time for the total debt, or some variation of it, is the number one choice for certain scenarios.

Humans are not perfectly logical beings. While we try to take actions based on calculations and facts, there is another, emotional, side of our decision making. The debt snowball technique acknowledges this as a limitation and adapts accordingly. Instead of clearing the highest costing debt first, it focuses on clearing the smallest, giving you an extra boost of motivation. Each time you fully pay off one of your debts, you get that sense of achievement that pushes you to stay on track. If you are struggling with clearing your debt despite having extra cash, this may be the best option for you. You can also combine it with other loan repayment techniques to come up with a hybrid that can benefit you even more.

Limitations

Like everything else in the world, this technique also has some limitations. These limitations should be carefully examined before applying it to yourself. Although the method is proven to be one of the best techniques for debt repayment, there may be other factors outside the scope of this model, and this article may influence negatively its application, reducing the savings, or even at times costing more.

The first limitation is that the technique does not include interest rates in its decision. If we are talking about savings but ignoring the interest rate, we are potentially losing out on extra savings that we could be making. For example, if you have two similar sized loans with different interest rates, it may be worthwhile to consider tweaking the strategy a bit to clear the slightly higher amount higher interest rate loan instead of simply focusing solely on the amount.

Another limitation of this debt snowball technique is that it ignores the fact that some of the loans have early payment penalties. This may reduce the financial benefit gained through the reduction in interest. The Student loans, car loans and some personal loans (generally longer-term financing instruments) usually have such clauses while credit cards and payday loans usually do not have any such penalties. Check the terms of your loan agreement to find out if it applies to you or not. If it does, the model should be adjusted accordingly.

The third limitation is less of a limitation, and more a suggestion. The model looks at one aspect of loans. However, there are other techniques that may as well be included with the model into your financial plan for clearing your debts. For example, balance transfer from one type of loan with a higher interest rate to the other type with a lower interest rate. This can further improve the results giving you higher savings while being quicker at clearing your debts.