DEFINITION of ‘Debt Snowball’
A method of debt repayment in which the debtor lists each of his/her debts from smallest to largest (not including the mortgage), then devotes extra money each month to paying off the smallest debt first while making only minimum monthly payments on all of the other debts.
Once the smallest debt is paid off, the debtor starts putting extra money each month toward paying off the second-smallest debt while continuing to make only minimum monthly payments on all other debts. The debtor continues this process, paying off each debt from smallest to largest, until all of the debts are paid in full. The debt snowball method is advocated by Dave Ramsey, the host of a popular call-in personal finance advice radio show and best-selling author of several books and programs on getting out of debt.
INVESTOPEDIA EXPLAINS ‘Debt Snowball’
Each debt’s interest rate is not a factor in selecting the order in which the debts are repaid using the debt snowball method. While repaying debts starting with the highest-interest debt and ending with the lowest-interest debt, a method called the “debt avalanche,” will cost debtors less in interest over the long run if they stick with the program, the debt snowball method can be more effective in reality because of the psychological benefits of generating a win each time a debt is paid in full.
Paying off five debts can seem more manageable if the list is quickly whittled down to a single debt by paying off the smaller debts first. The debtor might get frustrated and quit the repayment plan if the highest-interest debt were one of the largest debts and had to be repaid at the beginning of the plan.
Here’s an example of how a debt snowball works. Let’s say an individual can afford to put $1,000 every month toward retiring his three sources of debt: $2,000 worth of credit card debt (with a minimum monthly payment of $50), $5,000 worth of auto loan debt (with a minimum monthly payment of $300), and a $30,000 student loan (with a minimum monthly payment of $400). Using the snowball method of debt repayment, he will spend a total of $750 on paying each debt’s minimum monthly payment. He will put the remaining $250 toward the credit card debt, because it is the smallest of the three debts.
Once the credit card debt has been completely paid off, the extra payment will go toward retiring the second-largest debt, the auto loan. At that point, the debtor will be spending $700 a month on minimum monthly payments and will have $300 extra to put toward the auto loan each month. Once the auto loan is paid off, all $1,000 will go toward the student loan until it, too, is paid in full and the individual is debt free. Like a snowball, each paid-off debt frees more cash to go toward eliminating the remaining ones.