Note: The numbers used here are fictitious and are simply an example to help you understand the process.

Every debt you have carries a minimum payment.  Whether it’s your credit card, car loan, signature loan, or mortgage payment, you have a minimum that you need to pay every month.  In order to stay current, you have to make all of those payments (unless of course you’re unable to because of income.)

The Debt Snowball is a method that Dave Ramsey teaches that helps modify your financial behavior to build momentum towards your final payment of your last debt.  The key here is that you’re building momentum.

Let’s say, for example, you have 2 credit cards, one car loan, and a signature loan.

Credit Card 1: $2000.00 balance, $100 minimum variable payment.
Credit Card 2: $4000.00 balance, $200 minimum variable payment.
Car Loan: $10,000 balance, $380 minimum fixed payment.
Signature Loan: $5000.00 balance, $225.00 fixed payment.

(Note: credit cards have variable minimum payments.  This means they change from month to month based on the balance of the credit card.  Auto loans on the other hand typically have a fixed payment for the term of the loan.  Other loans that change from month to month or year to year are variable rate loans.  Variable rate loans suck.)

So, looking at your total debt load, you owe a total of $21,000 and your monthly minimum payments total $905.00 month.  Since some of your payments are variable, this minimum requirement will hopefully go down, if you’re on the path to recovery.

The Debt Snowball

Dave Ramsey teaches about the Debt Snowball in his best selling book on money management entitled The Total Money Makeover: A Proven Plan for Financial Fitness.  The concept is simple.

• Stay current on all of your minimum debt payments.
• Pour every extra penny you have (that means cutting back on your discretionary spending or getting an extra job) into the smallest debt you have until it is paid off.
• Rinse, repeat.

In our example, you would make sure you’re covering all minimum payments for all debts, and you’d throw every extra resource you have at the card with the lowest ($2000.00) balance.  As soon as that card is paid off, you would shift your minimum payment of $100.00 which is no longer needed for the first card to the second card.  Now, rather than just paying the second card’s $200.00 minimum, you’ll be paying $300.00 towards the balance, plus all of the extra money you can possibly come up with. As soon as you’ve knocked out the second card (remember, it was the one with the $4,000 balance) you move the entire $300.00 minimum payments that you used to have on the credit cards to the signature loan of $5,000.00, focusing a minimum of $525.00 ($300 + $225) plus all of your extra available money.

Here’s where you start to see the power in the debt snowball.  By the time you’ve knocked off the 2 credit cards and the signature loan, you’ve got only one left, and that’s the car loan which has a monthly payment of $380.00.  But you’re not going to just pay the car payment.  You’re going to pour the minimum payments of the previous 3 debts towards the car too.  So, instead of $380.00/month, you’ll be paying $905.00/month on the car, which is almost 3 times the monthly payment.

Every debt you knock off makes the payment towards the next debt that much more powerful.

Where Most People Go Wrong

Most people don’t have the discipline to roll the paid-off-payment into the next debt.  Most people would look at paying off a debt as an opportunity to free up the monthly payment to be used for other things; things that don’t contribute to the snowball.  Imagine paying off the 2 credit cards and the signature loan, and then settling for paying just the minimum payment on the car.  It doesn’t make sense, because over time, the longer a note is held, the more that is wasted in interest payments to the lender, and if someone has the earning power to make their minimum payments when they’re leveraged to the hilt, then they have that same earning power to continue pumping their debt full of snow, so to speak.

Notice I Didn’t Mention Interest Rates?

The reason I don’t pay attention to interest rates, even though mathematically, it would be better to do so, paying off debt isn’t a mathematical problem.  It’s a challenge to re-set behavior, and the best way to do that is to experience some triumphs along the way.

Imagine that your car loan of $10,000 was at 18% and your two credit cards for a total of $6,000 were each at 10%.  Would it make mathematical sense to pay off the car first?  Probably (not taking into account depreciation). However, it would take you the term of the loan to pay it off, and when you finished with the car, you’d be exhausted, and you wouldn’t feel like you had made any progress.

The principle amount on each loan is really the important number.  Even though you’re being charged interest, getting those principle amounts reduced is all that really matters.  The amount of interest over time is going to be insignificant to the feeling of accomplishment you’ll have when you pay off the lowest balance first, and when you start to see your minimum payments stack up on top of each other to hammer out the next smallest debt, you’ll really gain momentum.

The Debt Snowball chart that I created here shows the patterns of acceleration for each debt as the minimum payment of the previous debt is rolled into the next.  In this chart, interest has been omitted for simplicity, but it should be basic enough to understand that in 21 months, using the debt snowball, all debts would be paid off.  In fact, the first debt would be knocked out in about 12 months, followed by the second only 4 months later, then the third 2 months after that, and then the fourth only 3 months after that.  These are quick accomplishments in succession that will give you a sense of success.

Take a look at the chart below.  In this example, we’ve assumed that the interest rate on the largest debt is the highest, and the second highest rate is on the second highest balance, and so on.  If we tackle the largest interest rate first, here’s what happens, and remember that I’m not calculating interest into this example, so the results would be a bit different, but the general idea should be obvious.

You can see that you won’t even achieve your first payoff until the 21st month in the plan.  Granted, you’ll knock out two on the same month, and you’ll even pay off the car before you nail the signature loan, but you’ve carried the risk of 4 loans for the entire time instead of having a bit of wiggle room in your finances by month 12.  Remember, in the previous example, $100.00/month was freed up by paying off that lower balance first.  By the time you got to the 21st month, your total monthly obligation was only $380.00.  In the high interest first example, you carry a total of $905.00 in monthly obligations throughout the entire 21 months.

The Debt Snowball is a great way to eliminate debt, as long as you follow the plan through to the end, making sure you don’t compromise by using that extra money you’re saving on monthly payments for something other than the next smallest debt.

I’d be curious to see what this would look like fully calculated out with interest added in.  I know that it would make it look different, but I believe the same principal will stand true.  If you’re one to analyze these things, I’d be curious to know what you find.