The Snowball Effect of Spending Down Your Debt

The snowball debt payment is a system of debt reduction popularized by financial expert by Dave Ramsey. It advocates paying off your smallest debt first and working your way up to the largest debt. It has many supporters, but it has also received some criticism for ignoring interest rates.

How it Works

To use the snowball effect, order all your debts from smallest to largest. Each month, make the minimum payment on all the debts and then spend as much extra as possible to pay off the smallest debt. Once it's paid off, you then turn your money to the next debt on the list. It's called a snowball because as each debt is paid off, the minimum payment is added to the money used to pay off the next debt. Thus the amount of money available to pay each individual debt increases as you progress.

Advantages

The advantage of the snowball effect is that the quick payoff from targeting smaller debts provides motivation to continue aggressively paying down your debt. The system provides a steady flow of such victories to help you stay motivated.

Criticism

The main criticism of this approach is that it ignores interest rates when determining which debts to pay off first. Leaving larger, but higher interest rate, debts for last can cost you a lot in interest. Especially when credit cards can have interest rates of 20 to 29 percent. A $5,000 credit card balance at 25 percent would cost you more than $1,300 in interest in a single year. The same amount total made up of smaller loans at 8 percent interest would only rack up $400 in interest each year. So you can see, paying off higher interest loans can make a large difference in the amount of money you'll ultimately spend paying off your debts.

Alternatives

One obvious alternative is to change the order you pay off your debts to put the highest interest debts first. Another option is to consolidate your debts at a lower interest rate. This can be done by seeking a personal loan from the bank and using that loan money to pay off the others. This will give you one large loan to pay off, reducing the number of bills you have to keep track of and chances that one gets forgotten. Yet another option is to move your credit card debts to a new lower interest card, or use an introductory rate to save money while you pay it off. Just be careful that you don't get hit by interest higher than the original when the introductory period ends. Whichever path you choose, be sure that once you pay off those debts you keep your spending to what you can afford.