Dave Ramsey Debt Snowball Method Of Debt Repayment

by Mike Holman

snowballThe “debt snowball” method of debt repayment was popularized by “financial expert” Dave Ramsey.  The method was created for people who are having trouble paying off their debts and need some more motivation and a different strategy.  The basic idea of the snowball method is to pay off your loans in order from the smallest loan amount to largest loan and ignore the interest rates and minimum payments.  The benefit of this strategy is that the person paying off the debts will experience some early success (after paying off a small loan) and will be able to use that momentum to tackle the larger debts.  The more logical way to pay off your debts is to start with the highest interest loans and work your way down to the lower interest loans.  This is one of the Dave Ramsey baby steps.

The snowball method may result in the person paying more interest but as Ramsey says “Finances are 20% knowledge and 80% behaviour”.  In other words – sometimes you have to do what works for you rather than do the method which makes more financial sense.  At the end of the day, if you can get out of debt then you have won the war – does it really matter if you could have won a few more battles along the way by paying the high interest loans first?

How it works

The way to pay off your debts using the snowball method is as follows:

  • List all your debts by amount.
  • Determine the smallest loan to start paying off first.
  • Increase your regular payments to that loan and make any extra payments you can come up with.
  • Only pay the minimum amount to all your other loans – decrease the payment amount if necessary.
  • Once you pay off the first loan then you starting increasing the payments to the next largest loan so that your total payments are the same.

Example

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Susan has 3 loans which out detailed in the chart above.  She has a total of $30k in debt and the minimum payments are $1,000 per month.
To pay the loans off using the snowball she has to identify the smallest loan which is of course the $5,000 loan.  Susan has an extra $500 per month which she can put towards debt repayment so she applies that to the smallest ($5k) loan.
These are her new monthly payments:

  • $5k loan – $700 =  $200 min + $500 extra
  • $10 loan – $350 minimum
  • $15k loan – $450 minimum

Her monthly payments now total $1500.

Once the smallest loan ($5,000) is paid off then she now has to identify the next largest loan ($10k) and increase the payments on that loan.  When Susan first started her minimum payments were $1,000 – then she increased the payments by $500 to $1500.  By keeping her monthly debt payments to $1500 (even though she owes less money) she will get the full snowball effect.  When she started the method she was paying an extra $500 on one of the loans – now that she has removed one of loans, her payments now look like this:

  • $10k loan – $1150 = $350 min + $500 extra payments + $200 which was the minimum of the $5k loan which no longer exists
  • $15k – $450 minimum

You can see that she is now paying $700 above the minimum on the $10k loan which is a big increase from the $500 extra she was paying on the smallest $5k loan.  This is the snowball effect.

Once she pays off the $10k loan then she can apply the full $1500 per month to the last $15k loan.  Since the minimum payment is only $450 – she is now paying an extra $1050 per month towards the last loan.  By paying off the loans and adding the payment amounts to the remaining loans, the extra payment is increased as each loan is paid off so your payment “snowballs” and your debts will get paid off quicker and quicker.

snowball

Should I use the Dave Ramsey snowball method?

I would strongly suggest that you try to pay off your debts with the higher interest rates first – however if that strategy isn’t working for you then the debt snowball method might be a good thing to try.

Some scenarios where the DRS is good or not so good from a financial point of view.

1)  If your smaller loans are also your highest interest then it works well

2) If your loan interest amounts are similar then using the snowball method won’t make much of a difference.

Scenario:

15k loan at 6%, min payment is $100

20k loan at 15%, min payment is $200

Let’s say you have an extra $500 per month to put into the loans.  If you follow the Dave Ramsey method then you will put the extra $500 into the smaller $15k loan until it is paid off – then you will put the extra $500 plus $100 into the larger loan until it is paid off.  According to my spreadsheets – the total interest paid will be $8278 and the loans will be paid off in 50 months or 4 years, 2 months.

If you didn’t follow the Dave Ramsey method and paid off the higher interest loan first – the total interest paid is $5132 and both loans are paid off in 45 months.

In this case the Dave Ramsey method would be very expensive, costing an extra $3146 in interest and would take an extra 5 months of payments.

Some things to think about

If the lower interest rate loans are small (in terms of how long it will take to pay off) then it doesn’t matter that much if you pay them off first.  The absolute amount of the smaller loan isn’t that important but rather how long it will take to pay off .  If the small loan can be eliminated in a few months, then the extra interest cost will probably not be that significant.  An example is provided by Frugal Dad recently who was so close to paying of his Tahoe that he decided to put all extra payments into that loan even though it wasn’t his highest interest loan.

The difference in interest rate of your loans is also very important.  If the interest rates are pretty close to each other then paying the lower interest loans first won’t cost that much more than paying off the higher interest loans first.

Photo credit tjflex

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{ 7 comments… read them below or add one }

1 NB

For most people, getting into debt probably did not occur while practicing sound financial planning, though I agree that bad things can happen to prudent people. Likely, the root cause of financial trouble was a set of spending habits that were developed based on a false sense of entitlement or emotional responses. The idea of suddenly turning a person’s financial habits around, having them follow prudent financial planning after years of emotionally-guided spending is not reasonable. I believe that a regiment of sound financial planning, such as paying off debts with the highest interest first, would set most debtors up to fail. There is no appeal in that type of planning, for people who have been conditioned to respond to finances emotionally.
A solution like the debt snowball seems to play to the emotional side of debtors. They get to celebrate victories early in their new spending plan as they eliminate individual debts. Setting them up for wins early in their new financial plan makes sense.
Based on the above reasoning, paying debts with the largest ratio of minimum payment to balance outstanding seems to make the most sense for most people because it delivers them victories early in their new financial plan.

2 Mrs. Pillars

When I had student loans to pay off, there was a small one that was prime plus one and a larger at prime plus two. When I called the bank one day their recorded message said, “Your interest is accumulating at $3.43 per day”. I didn’t need any more motivation than that to start throwing every little extra bit against the higher interest loan. To keep my motivation, I created a spreadsheet (yes, Mrs Pillars is a nerd) to track by how much each extra payment changed that interest amount. What a good feeling it was to get rid of those loans!

3 nobleea

I wonder if people would be in as much debt if all banks and credit card companies called you with a recorded message every friday that said “Your interest is accumulating at $XX per day”. Randomize the times and phone numbers.

4 Gaby A.

How about this way. Rank the interest $$ amount from highest to lowest. Pay the minimum on all debts/credit cards, and for the highest one or two items (or more if you can swing it), take the money you were going to use for savings and allocate 50% to the highest card(s) and 50% reserved for short term savings for emergencies. Once you build up your emergency reserve, take the 50% that would have gone there and place in an RRSP. The money to pay with here assumes all other necessary expenses, including mortgage are being take care of first.

This is modified from a method by David Bach, called the DOLP method, http://finance.yahoo.com/expert/article/millionaire/40724 , although he ranks it a bit diffferently and it’s aimed more at Credit Card debt. I take the approach to pay off the largest amounts first while still paying the minimums on everything else. No time like the present to get more disciplined.

5 Nicolas

Nobleea,

I seriously think that you are onto something interesting there. As emotions are obviously unavoidable (unless you are a robot), a daily reminder could help individuals a lot. A kind of financial coaching (more like boot camp) I guess.

Quick, incorporate a company for the purpose of holding the patents on the process. Then start a parallel post series on FP (with permission) called “Perhaps not so whacky business ideas”.

Only downside is that the friendly reminder would soon piss off people to which the counter argument is: making them pay off there debts faster to get rid of the reminder.

6 Mike

I agree – Nobleea, that’s a pretty neat idea.

7 Jeff

In my case I paid off lower balance debts to improve my cash flow situation. This allowed me the breathing room to pay cash for current expenses and then allocate extra money to pay down my high interest debts.

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