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Being in financial debt can be a huge burden and whilst paying off debt is no easy task, it will nevertheless bring financial freedom. There are two distinct methods to pay off debt: the debt snowball method and the debt avalanche way. While both are useful strategies to clear your debts, today’s article will focus on the debt snowball method.
What is the debt snowball?
The debt snowball is a debt strategy where by someone who owes debt on more than one account pays off the account with the smallest balance first, whilst paying the minimum amount on the larger debts. Once the smallest debt is paid off, the next smallest debt is tackled using the payments allocated from the smaller debt before and so and so forth, until all debts are paid off. This method is contrasted with the debt stacking method or debt avalanche method, which pays off the accounts with the highest interest rates first.
The basic steps in the debt snowball method are as follows:
- List all debts in ascending order from smallest balance to largest. Note: The smallest debt is tackled first, not the highest interest rate.
- Commit to pay the minimum payment on every debt.
- Determine how much extra can be applied towards the smallest debt and commit to that amount until that debt is paid off
- Once a debt is paid in full, add the old minimum payment (plus any extra amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new sum to repaying the second smallest debt.
- Repeat until all debts are paid in full.
In theory, by the time the final debts are reached, the extra amount paid toward the larger debts will grow quickly, similar to a snowball rolling downhill gathering more snow (thus the name).
A person has the following amounts of debt and additional funds available to pay debt
-Credit Card A – $250 balance – $25/month minimum
- Credit Card B – $500 balance – $25/month minimum
- Loan – $2000 balance – $200/month minimum
- The person has an additional $100/month which can be devoted to repaying debt.
Month one and two:
- Credit Card A – $125 ($25/month minimum + $100 additional available)
- Credit Card B – $25/month minimum
- Loan – $200/month minimum
In the third month, the balance of Credit Card A would have been paid in full, and the remaining balances as follows:
- Credit Card B – $450
- Loan – $1600
Third month payments – the person would then take the $125 previously used to pay off Credit Card A and apply it as additional payment to the Credit Card B balance, which would make payments for the next month as follows:
- Credit Card B – $150 ($25/month minimum + $125 additional available)
- Loan – $200/month minimum
Three more months (six total) – Credit Card B would be paid in full, leaving just the loan outstanding at $1000
Using the $150 to pay off credit card A and B, the use this as an additional payment to pay off the loan balance, which would make payments as follows:
- $350 x 4 monthly payments, with a final payment of $200 in the last month.
The primary benefit of the smallest-balance plan first is psychological-the benefit of seeing results sooner. In this case, the debtor sees reductions in both the number of creditors owed (and, thus, the number of bills received) as well as the amounts owed to each creditor. This method is further reinforced in a 2012 study where researchers found that consumers who tackle small balances first are more likely to eliminate their overall debt than trying to pay off high interest rate balances first, whilst a 2016 study in Harvard Business Review came to a similar conclusion. However from a mathematical point of view, this leans more towards paying the highest interest first under the debt avalanche method.
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