Popular radio talk show host Dave Ramsey harps on debt, and for a good reason. In October, The Federal Reserve Bank noted that total household debt in the United States had reached $16.51 trillion. $925 billion of that is unsecured credit card debt. Despite millions being paid down in 2020 and 2021, credit card debt is back at near-record levels.
Debt destroys our ability to build wealth. So getting out of bad debt should be your top priority. There are several ways to go about that, each with their unique plusses and minuses.
The Debt Snowball method, popularized by Ramsey, is a debt reduction strategy that prioritizes debts by their size, starting with the smallest. The idea is simple. Make extra payments on your smallest debt to get rid of it, then apply that same payment to the second small debt, and so on.
Debt interest rates do not matter. All debts are ordered from smallest to largest.
How Debt Snowball Operates
To illustrate how Dave Ramsey’s Debt Snowball method works, let’s use an example.
Suppose you have five debts:
- Credit card: $1,500 ($52 payment)
- Student loans: $12,200 ($110 payment)
- Car loan: $9,500 ($95 payment)
- Medical bill: $450 ($75 payment)
- Owe a friend: $500 ($50 payment)
Step 1 is to order these debts from smallest to largest:
- Medical bill: $450
- Owe a friend: $500
- Credit card: $1,500
- Car loan: $9,500
- Student loans: $12,200
You will make minimum payments on all five debts.
Then, make additional payments to eliminate the $450 medical bill first. Then, take that medical payment and apply that to the $500 that you owe your friend. Once your friend’s debt is done, move on to your credit card debt, car loan, and student loans.
For instance, making an extra $50 payment a month on your medical bill eliminates the debt in four months.
The math: $75 minimum + $50 extra = $125 a month.
You're done with a $450 medical bill in four months and off to your next debt.
Does The Debt Snowball Method Work
The biggest problem with the Debt Snowball method is how debts are prioritized. Instead of ordering debts by interest rate, debts are ordered by their size. This means you’ll likely pay more in interest using this method.
If you're curious, the Debt Avalanche method prioritizes debts by interest rate, not size. The avalanche method might work best if you want to reduce interest payments.
Ramsey argues that the snowball method works because it changes financial behaviors. It's so essential, Ramsey argues, that it's Step 2 in his famous “Baby Steps” program designed to help you build an emergency fund, get out of debt and build wealth.
“The point of the debt snowball is behavior change,” Ramsey said on his website. “If you try to pay off your student loan first because it's the largest debt, you won't see results for a long time.”
The snowball method makes debt elimination easier because you will see progress much faster. Knocking out your smallest debt is more straightforward than tackling your largest. Those smaller wins may keep you motivated to continue paying off your debts.
Many people use the snowball method to get out of debt. But you will be paying more in interest before getting there.
“The truth about the debt snowball method is it’s a motivational program that can work at eliminating debt, but it’s going to cost you more money and time – sometimes a lot more money and a lot more time – than other debt-relief options” argues Debt.org.
Consider The Debt Avalanche Approach
The Debt Avalanche method is the primary alternative to the snowball method.
In general, you will likely pay less by paying off debts in order of interest rate, not size. However, paying off your first debt may take significantly longer.
To illustrate how the avalanche method works, let’s use the same example from above:
- Credit card: $1,500 (18.99% interest)
- Student loans: $12,200 (4.53% interest)
- Car loan: $9,500 (3.61% interest)
- Medical bill: $450 (1% interest)
- Owe a friend: $500 (0% interest)
All debts are ordered by interest rate, from highest to lowest.
Using the Avalanche Method, we make additional payments to eliminate our high-interest credit card debt. Then, we apply that payment as an additional payment to our student loans, our second-highest interest payment.
Which method works best will heavily depend on what motivates you.
Debt Consolidation May Be an Option
The alternatives don’t stop there.
Debt consolidation loans are also good options for some people.
Debt consolidation loans combine high-interest debts, allowing you to make a single monthly payment on all debts. These loans are good options for people with a credit score of at least 650.
This is an excellent option if you can get a consolidation loan with a lower interest rate than your individual debts. You'll pay less interest and enjoy the convenience of making a single payment rather than separate payments.
The process is simple. Once a debt consolidation loan is approved, the lender will transfer funds into your bank account. Pay off each of your debts using lump sum payments. Then, you will only have a fixed amount to the consolidation lender.
There are downsides to debt consolidation loans, however. Many of these loans have initiation fees, balance transfer payments, and closing costs. Some even charge an annual fee. In addition, your interest rate is based on your credit score, so it’s possible that your interest rate on a consolidation loan would be higher than the interest on your individual loans.
This article was produced and syndicated by Wealth of Geeks.
Steve Adcock is an early retiree who writes about mental toughness, financial independence and how to get the most out of your life and career. As a regular contributor to The Ladders, CBS MarketWatch and CNBC, Adcock maintains a rare and exclusive voice as a career expert, consistently offering actionable counseling to thousands of readers who want to level-up their lives, careers, and freedom. Adcock's main areas of coverage include money, personal finance, lifestyle, and digital nomad advice. Steve lives in a 100% off-grid solar home in the middle of the Arizona desert and writes on his own website at SteveAdcock.us.