Welcome to our week-long series on crushing your credit card debt. In this third of five articles, we look at how to supercharge your get out of debt program with the Debt Snowball.
Let’s cut right to the chase. Using the debt snowball method can save you thousands of dollars in interest payments and significantly reduce the time it takes you to get out of credit card debt.
The debt snowball is a method for paying down any debt, not just credit cards, and it’s extremely easy to implement. So let’s take a look at how it works.
What is the Debt Snowball
The idea of a debt snowball is really simple:
Step 1: Make a list of all of your credit card debts (you can include other debts as well, such as school loans, auto loans, and home equity loans).
Step 2: For each loan, list the creditor, the outstanding balance, the monthly minimum payment, and the interest rate.
Step 3: Add up the minimum monthly payments due, and continue to pay at least this amount until all of your debts are paid in full. That means that when the first debt is paid in full, you’ll take the money you were paying toward that debt, and put it toward another debt.
Two things make the debt snowball a powerful tool. First, the minimum payment on a credit card goes down as the balance goes down. Most credit cards calculate the minimum payment as a percentage of the outstanding balance. While the actual percentage applied by credit cards varies, a range of two to four percent is common. That means that after just one payment, your minimum payment will go down the next month, assuming you haven’t added any charges to the card. By keeping your payments constant, however, more and more of each month’s payment will go toward your balance instead of interest.
Second, as one loan is paid in full, you put the extra money toward another credit card balance. This further accelerates the paying of your total debt. And when the second card is paid in full, you take the extra cash each month and put it toward your third card. And you keep following this approach until all of your debt is gone.
How Much Does the Debt Snowball Really Save?
To see the power of this approach, let’s look at an example. We’ll assume that you have the following three credit cards with balances:
We’ve also assumed that the minimum payment is calculated by taking 2 percent of the outstanding balance. With these assumptions, the current minimum payment for all three cards combined is $340.
Minimum Payment Approach
Now, if you continue to make just the minimum payment each month, that amount will slowly go down as your balances go down. With that approach, how much will you pay in total interest and how long will it take to pay off the balances in full? I hope you’re sitting down for this–
- Total Interest Payments: $49,007.43
- Years to Debt Freedom: 60 years and 11 months
Don’t believe the math? Try it for yourself with this calculator from CNN.
Debt Snowball Approach
If instead you continue to make the initial minimum payment of $340 until all debts are paid and apply the extra cash to the card with the highest interest rate, the results change dramatically:
- Total Interest Payments: $12,365.57
- Years to Debt Freedom: 7 years and 3 months
The numbers speak for themselves.
Debt Snowball on Steroids
So far in our examples we’ve calculated the current minimum payment and assumed you’ll continue to pay this amount until the debt is gone. Using the same example above, let’s now assume that you can throw an extra $50 a month on the debt. So instead of paying $340, you’ll pay $390 until you’ve killed your debt.
How will this affect total interest paid and time to debt freedom? Here are the numbers:
- Total Interest Payments: $8,979.83
- Years to Debt Freedom: 5 years and 7 months
In other words, just an extra $50 a month will shave nearly two years off your time to debt freedom and more than $3,000 in interest payments. Here’s a screenshot from the calculator I used to get these results:
Which Debt Should You Pay First
You may have noticed in the above examples that we’ve been applying extra cash to the credit card with the highest interest rate. Not everybody, however, recommends this approach. Dave Ramsey is well known for his advice to pay the loan with the lowest balance first. He recommends this approach even if you have other loans with much higher interest rates. His rationale is that by picking the debt with the lowest balance, you’ll get it paid off faster.
I don’t want to get into whether Dave Ramsey is right or wrong. But it is important to realize that following Dave’s approach may cost you thousands of dollars in extra interest payments and take you longer to get out of debt.
Using are example from above, let’s assume that you continue to pay $340 a month until you’ve extinguished your debt. In this example, however, any extra cash goes to the card with the lowest balance. With Dave’s approach, here are the results:
- Total Interest Payments: $13,934.00
- Years to Debt Freedom: 7 years and 7 months
Now the difference may not seem like much. Compared to paying the cards with the highest interest rate first, Dave’s approach takes just 3 months longer. But his approach costs about $1,500 more in interest payments. Dave’s approach is also silly if you take the steps we suggest to lower your credit card interest rates. Imagine snagging a 0% balance transfer offer, for example, and then throwing all your extra cash to that card because it has the lowest balance.
It’s worth noting that not every case will result in such stark results. In our example the cards with the higher balances also had the higher interest rates. But regardless of the specific circumstances, putting extra money on the debt with the highest rate will net you the best result.
Debt Snowball Gotchas
As easy as this debt repayment method is, there are several ways to go wrong:
- Watch out for more debt. The most important part of getting out of debt is to stop going into more debt as we’ve covered previously. While sometimes debt is outside of your immediate control, often times debt is the result of bad choices. So do everything in your power to avoid new debt.
- An emergency fund is a must. Having some money set aside for the unexpected bills will help you avoid more debt.
- Work on your credit. With an improved credit score, you can often times get interest rates on your debt lowered. In the case of a credit card, it can be as simple as a phone call. With auto loans and home equity lines, it will likely require a refinance, but the savings can be substantial.
In the next article in our series on crushing credit card debt, we’ll look at Ways to Free Up Extra Cash that you can put toward your debt.