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There are many different techniques you can use to repay the money you owe. But one of the most popular budgeting methods is called the debt snowball. The debt snowball was promoted by personal finance guru Dave Ramsey as a way to pay off debt more easily with human psychology in mind.
You see, with the debt snowball method, you make minimum payments to all creditors, but you make additional payments first on the debt with the lowest balance. That way, you should hopefully pay off that debt quickly, which will help keep you motivated to continue lowering your credit balances.
There’s just one obvious problem with this: Debt that you have the lowest balance on may have a lower interest rate than other loans that charge much higher rates. If so, you’ll focus on paying off cheap debt first while keeping your debt at high interest longer – and continuing to pay more interest over time.
While the idea of ​​scoring quick wins to stay on track certainly has merit, you should know how much the debt snowball method could end up costing you.
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The debt snowball strategy comes at a high price
The exact amount of additional interest that you will end up paying due to the use of the debt snowball strategy will vary depending on your personal circumstances. The main determining factors are the larger the interest rate difference on your debt and the longer it takes to start tackling your high rate loans.
But to give you an idea of ​​how much this strategy could cost you, let’s look at an example. Let’s say you need to:
- $ 1,000 on a personal loan at 5% interest and $ 150 in minimum payments
- $ 1,500 on a credit card with 17% interest and minimum payments of $ 40
- $ 2,500 on a car loan with an interest rate of 4% and monthly payments of $ 200
- $ 5,000 on a business loan at 7% interest and $ 175 in monthly payments
- $ 6,000 on an in-store credit card with 27% interest and monthly payments of $ 195
If you follow the snowball approach, you’ll pay off the debt in the order they’re listed here, starting with paying off your personal loan, and then ending with paying off your store credit card. This approach to debt repayment would take you 26 months and cost you a total of $ 19,266 to pay off your entire loan balance.
But what if you paid off your debts with the highest interest rate first. This could mean starting with the store card, then the 17% interest card, followed by the business loan, and so on, up to the 5% personal loan. This method is called the debt avalanche method. With this approach, you would be debt free in 24 months, and you would only spend a total of $ 17,855 to pay off what you owe.
The snowball method in this case would have cost you an additional $ 1,411 and required you to repay your loans for two more months.
Now Ramsey encourages you to make extra payments using the snowball method, and paying extra each month would speed up the payment time using either approach. But even though additional payments would reduce the total debt repayment time and provide more interest savings over time, they wouldn’t change the bottom line. Your total payment costs would be significantly higher if you paid off your debt from low to high balance rather than high to low interest rate.
Should we use the snowball method?
Your calculations may look different from these, but in almost all cases the snowball method will end up costing you more over time.
Now, you can decide that you have to use the snowball method anyway because it is the best budgeting method for your personality. For example, if you don’t get the psychological benefits of seeing some of your debt go away quickly, you’ll have a hard time staying on track with paying off your debts. But there are other ways to stay motivated, including using visual tools like a thermometer to color in as you get closer to your debt repayment goal.
You may also have the option of consolidating your debt, that is, taking out a new loan at a lower rate to repay all of your various creditors. If possible, you would greatly simplify repayment and not have to choose which debt to pay first. Plus, I hope you save some money in the process.
At the end of the day, if you take any approach to trying to pay off your debt, you are making a smart financial move. But just know that the snowball method can will cost you, so be sure to consider the downsides.
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