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Debt Reduction: Snowball Method

There are multiple ways to reduce your total (and monthly) debt load, some less painful than others.

The obvious one, of course, is to simply pay down your debts. That can be difficult, and for some it may seem hopeless. But there is one method that has been employed by many with great success: the snowball method (so named by Dave Ramsey).

The technique is, in essence, very simple. Order your debts from lowest to highest. Pay the minimum required on all monthly debts, then allocate any remaining funds you can to paying off the smallest debt. Thus, the smallest debt will get paid off first. This frees up yet more money to apply to the next-smallest (now the smallest) debt. Repeat until you have reached the level you want.

This method has several advantages. You see regular, visible progress in reducing your debts and in a relatively short period of time you could well be down to a livable level. As you roll-off those debts, you have more free income which can be split between payments on the debt next in line and the enjoyment of some rewards.

Psychologically, this helps keep the debtor motivated to continue the program. Seeing real progress helps one stick with it during a financially challenging period.

But, for all its virtues, the method does have one real drawback. It actually requires more time (and money) overall to pay off all your debts that way. The reasons have to do with how interest compounds.

If you pay off a $1,000 debt, a $2,000 debt and a $10,000 debt they may all have the same rate of interest. But paying off the lowest amount first actually costs you more in total interest paid. Since any outstanding amount is charged at the same rate of interest, the higher amount will incur the largest charge. As a result, over time, you will pay more in total interest charges.

Reversing the order, paying the highest amount first, actually saves you money in the long run. As you pay down the highest debt first, you are reducing the amount of interest dollars paid over time.

The difficulty is that the latter method, though more cost effective in the long run, is harder for most people to stick to. It takes a lot of discipline to live with that debt burden as you slowly reduce the $10,000 debt.

At most interest rates, the lower debts will actually get paid off first. But in the meantime you are making high monthly payments. That takes a lot of willpower every month.

That willpower is the one thing that a lot of people too deep in debt find hardest to generate. It's the factor, often, that led to excessive debt in the first place.

For such people, using the snowball method may well be an advantage, despite the larger total amount paid out over the life off all the debts combined.