Nearly every financial adviser always advises that debts should be paid off in a particular order: from highest interest rate to lowest interest rate. While this method makes sense from a mathematical point of view, it makes less sense from a psychological point of view.
Psychologically, 7 outstanding debts feels more overwhelming than 2 outstanding debts even if they are at the same total balance. Many people are struggling with debt and have tried on several abortive attempts to eliminate their debt using the highest-to-lowest method, and each time they failed. Why?
Because this payoff plan does, indeed, make the most financial sense if you have the discipline to adhere to it. By paying off the high interest rate debt first, you are minimizing the total you will eventually pay in interest. But this method does not work for everyone.
For many debtors, their highest interest rate debt was also their debt with the highest balance. Psychologically, they felt defeated; they could pay on this debt for months at a time and never seem like making the progress.
Dave Ramsey, the financial expert and the nationally-syndicated talk radio host of The Dave Ramsey Show has introduced Debt-snowball Method as the alternative to the highest-to-lowest method in paying off the debt. His method had been recognized to make more sense from a psychological point of view.
Hows Debt-snowball Method Work?
The basic steps in the debt snowball are:
List all debts in ascending order from smallest balance to largest.
Commit to pay the minimum payment on every debt.
Determine how much extra can be applied towards the smallest debt.
Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off.
Then, add the old minimum payment from the first debt to the extra amount, and apply the new sum to the second smallest debt.
Repeat until all debts are paid in full.
In theory, by the time the final debts are reached, the snowball will be rolling quickly as it has picked up a lot of financial mass. Hence, larger debts will be paid off faster.
Let take an example to illustration the Debt-snowball Method. Assume a typical young woman in her mid-twenties who awakes one morning to realize that shes in debt and decides to do something about it. She might be burdened with the following hypothetical liabilities:
30,000 college loan at 5%
10,000 credit card balance at 12%
2,000 computer loan at 10%
3,000 car loan at 4%
The highest-to-lowest method would advise her debt to be paid off in this order:
10,000 credit card balance at 12%
2,000 computer loan at 10%
30,000 college loan at 5%
3,000 car loan at 4%
But, using the Debt Snowball method, she should organize her debt from smallest balance to largest balance as follow:
2,000 computer loan at 10%
3,000 car loan at 4%
10,000 credit card balance at 12%
30,000 college loan at 5%
After you have listed your debts from smallest to largest; pay the minimum amount on all of them except the smallest. Throw every pound you can scrimp and save against your smallest debt until it has been eliminated, then move on to the next-smallest debt.
Summary
In short, the Debt-snowball Method is another method to help a debtor to clear off his debt in more psychological way: by reducing the number of debts first as compare the total debt amount. Those who are unsure of their ability to stick with the plan may want to pay the smallest debt first, because the thrill of eliminating an entire balance sooner may encourage them to continue.
The amount of debt in this world is bountiful. When I say debt most people rear their head in disgust and hatred. The word debt is often associated with such feelings. The fact of the matter is though, that without debt you couldn’t’ have credit. Credit may be the reason you have a house, or even the reason that you could buy your first car. So when you hear the D word again second guess yourself as to the true connotations of the word. Credit has probably saved you many a time.