Debt snowball method

The basic steps in the debt snowball method are as follows:

1. List all debts in ascending order from smallest balance to largest. This is the method's most distinctive feature, in that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the debt with the higher interest rate would be moved above in the list.
2. Commit to pay the minimum payment on every debt.
3. Determine how much extra can be applied towards the smallest debt.
4. Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off. Note that some lenders (mortgage lenders, car companies) will apply extra amounts towards the next payment; in order for the method to work the lenders need to be contacted and told that extra payments are to go directly toward principal reduction. Credit cards usually apply the whole payment during the current cycle.
5. 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.
6. 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, hence the name.

The theory appeals to human psychology: by paying the smaller debts first, the individual, couple, or family sees fewer bills as more individual debts are paid off, thus giving ongoing positive feedback on their progress towards eliminating their debt.

An example of the debt snowball method in action is shown below. In a real payoff scenario the different interest rates on debts will affect payoff times and might make the method less efficient than other plans. However, for the sake of illustrating the method, the example ignores accruing interest.

A person has the following amounts of debt and additional funds available to pay debt (the debt is listed with the smallest balance first, as recommended by the method):

• Credit Card A – $250 balance – $25/month minimum
• Credit Card B – $500 balance – $26/month minimum
• Car payment – $2500 balance – $150/month minimum
• Personal loan – $5000 balance – $200/month minimum
• The debtor has an additional $100/month which can be devoted to repayment of debt.

The additional $100 is first directed toward Card A and, together with the $25 minimum payment, pays off the balance in two months. This is illustrated in the following table, with the prioritized debt indicated in bold.

Paying off Card A leaves $125 free for additional payment: the original $100, plus the $25 previously committed to minimum payments on Card A. This amount is added to Card B's $26 minimum payment, thereby paying it off in three more months.

A total of $151 is then free for additional payment, and is applied to the car loan for a total monthly car payment of $301. This pays off the car loan in another six months.

The available $301 would then be added to the personal loan's minimum payment for a total payment of $501. This would pay off the personal loan in another six months, leaving the debtor debt-free after a total of 17 months. Since the example omits interest, any payment order could pay off the debts in the same amount of time, but the snowball method avoids long waits between successive payoffs. If the debtor had prioritized debts in the reverse order, the first payoff (Card A) would have taken ten months and the rest an additional seven.

In situations where one debt has both a higher interest rate and higher balance than another debt, the debt snowball method prioritizes the smaller debt even though paying the larger, higher-interest debt would be more cost-effective. Several writers and researchers have considered this contradiction between the method and a strictly mathematical approach. In a 2012 study by Northwestern’s Kellogg School of Management, researchers found that "consumers who tackle small balances first are likelier to eliminate their overall debt" than trying to pay off high interest rate balances first.[5] A 2016 study in Harvard Business Review came to a similar conclusion:

We tested a variety of hypotheses and ultimately determined that it is not the size of the repayment or how little is left on a card after a payment that has the biggest impact on people’s perception of progress; rather it’s what portion of the balance they succeed in paying off. Thus focusing on paying down the account with the smallest balance tends to have the most powerful effect on people’s sense of progress – and therefore their motivation to continue paying down their debts.[6]

Author and radio host Dave Ramsey, a proponent of the debt snowball method, concedes that an analysis of math and interest leans toward paying the highest interest debt first. However, based on his experience, Ramsey states that personal finance is "20 percent head knowledge and 80 percent behavior" and he argues that people trying to reduce debt need "quick wins" (i.e., paying off the smallest debt) in order to remain motivated toward debt reduction.[7]

Research by Moty Amar and colleagues agreed that debtors are inclined to pay small debts first, which they attributed to "debt account aversion", the desire to reduce the number of outstanding debts regardless of balance or interest expense.[8] However, they also found that when debtors are restricted from fully paying debts and are shown the interest that will accrue as a result of their choice, they make the mathematically optimal decision.[8]

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