Basics of Snowballing
Snowballing, or the debt snowball method, is a technique of debt management that is used to repay revolving credit like credit cards. It involves paying the debts with the smallest amount owed first using any available extra cash. It has been taught by many financial and wealth experts lately.
The basic steps of snowballing are as follows:
First, you list all your debts from smallest balance to largest. This is the most distinctive and counterintuitive aspect of the plan in that this order is determined by amount rather than interest. In other words you might be putting your highest interest account as your lowest priority.
Next you must pay the minimum on every debt on time every time.
On the smallest debt, you pay the minimum plus whatever extra you can afford until it is paid off. Some lenders may apply extra amounts toward the next payment whereas others will put it directly toward principal reduction. You may have to contact them to have them put it directly toward principal reduction.
Rinse and repeat until your debts are gone.
In theory, the amount toward the bigger debts will grow quickly as the smaller ones are paid off (you keep paying approximately the same every month in total). Thus the name—the amount you pay toward the larger debt grows like a snowball rolling down a hill, gathering more and more snow as it rolls along.
The theory is as much rooted in human psychology as it is in financial theory. By paying the smaller debts first, you see fewer bills, and this reinforces the psychological impression that you are making progress, which is very valuable in keeping you on the plan.
You won’t typically include your home mortgage in the debt snowball, that is typically paid according to a different plan in a later step. Many financial plans pay off those mortgages in a later step. This is for debts that are greater than half of one’s annual take home pay.
Whether one should make retirement contributions during the debt reduction process is a matter of dispute among proponents of this method, because some contend that contributions should be halted on the grounds that greater gains are made by paying debt, and others compromise by saying the contributions should be reduced to the minimum amount in order to get matching but not eliminated, but most experts say the halting should not last more than two years.
People with a lot of financial discipline may choose to pay off their higher interest rate debts first. Ultimately, this will cost less in interest payments than the smallest balance approach, but lacks the psychological advantage of showing perceptible progress in paying off your debt.
