Why You Should NOT Snowball Your Debt Payment
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At work today, we had a lunch and learn with a financial advisor about how to create a budget and get out of debt.
I stayed behind to have a discussion with the advisor afterwards. When I told him that our only debt was our mortgage, we don’t carry any credit cards, we have an emergency fund, and we pay cash for our vehicles, he looked impressed and slightly confused as to why I chose to attend this class.
I told him that I love learning about budgeting and found his talk to be extremely informative. The biggest takeaway I had?
You are more likely to spend more money than you save using the Debt Snowball Method.
If you are trying to pay off your debts, chances are you have come across the teachings of Dave Ramsey, the financial guru known for his “Baby Steps” to financial freedom. Baby Step #2, his Debt Snowball Method, might be his most well-known Baby Step – at least, it is within my personal social circles. So you can imagine my surprise when I learned from an expert that it’s actually probably his worst advice. Instead of the Debt Snowball Method, you should really be following the Debt Avalanche Method.
What is the Debt Snowball Method?
Made popular by Dave Ramsey, the Debt Snowball Method is the method of debt repayment where you the minimum balance to all your debts, and pay extra on your lowest balance.
After you have paid off your first bill, you apply the amount of money you used to pay off the first debt (minimum + extra) and apply that to the minimum payment on the second smallest debt, and so on and so forth.
The idea is that the amount of money applied to one debt gets progressively larger as you keep bankrolling your debt payments.
This sounds good, but as I learned from the financial advisor, it’s actually not the most effective – or cheapest – method of debt repayment.
What To Do Instead of Debt Snowball Method?
The key to saving money while paying off debts is to look at the interest rates, and to pay off the loans with the highest interest rate first.
So instead of organizing your debts smallest to largest and paying them off that way, the financial advisor recommended the Debt Avalanche Method – which means you organize your debts by interest rate. Like the Debt Snowball Method, you will pay the minimum on all balances, but pay extra on the highest interest debt. Once it is paid off, pay that amount (minimum + extra) plus the minimum on the second highest interest debt, and so on.
Why Use the Debt Avalanche Method
Have you ever actually paid attention to the compound effect of interest rates? When used in your favor, like a 401k account, of course we are huge fans.
But obviously we aren’t the only ones who know about interest rates – banks are huge fans when it comes to loan repayments.
I did a quick calculation for our mortgage, and it absolutely shocked me. If I just mindlessly paid our mortgage each month according to our 30 year fixed rate, I would pay the bank an extra $263,000! Needless to say, I’m applying extra money to our principal each month now to pay off our loan early.
The Debt Avalanche method applies the highest repayment amounts to the highest interest rate, which limits the amount of interest that can accrue during that time. It also starts slow but trickles down quickly once the highest interest-accruing debt is paid off – hence the “avalanche” analogy.
Pros and Cons
What is the biggest draw of the Debt Avalanche system?
The savings! The Debt Avalanche slows down the amount of interest earned during your debt journey.
The downside? According to the financial advisor, often the debts with the highest interest rates are the largest amounts. These debts take longer to pay off, meaning that the process starts off slow.
The draw of the Debt Snowball system is that smaller debts get paid off fast, which does well for the psyche of the person paying off the debt, as it assumes progress.
The progress made with the Debt Snowball means the quantity of the debts disappears faster (because the total amount spent is lower), but you will pay more in the interest in the long-term.
Dave Ramsey’s Financial Freedom Baby Steps
The Debt Snowball is only Baby Step #2 in Dave Ramsey’s Financial Peace course, right after saving $1,000 for an Emergency Fund. After all debts are paid, Baby Step #3 is saving 3-6 months of your salary.
Wouldn’t you like to save money and get there faster?
My guess is the organizational method of smallest to largest debt vs largest to smallest interest rate was chosen as more of a psychological encouragement (“one debt left!”) rather than the more boring system that gets faster at the end, but saves you potentially a lot of money in the long run.
Which would you prefer? Leave me a comment and let me know!
If you are looking for more tips and helpful ways to get you out of debt fast and creating the life of financial freedom you have been hoping for, join the Budget to Bank self-paced course! Learn my methods for budgeting, making your money work for you, and how to change your mindset to get out of the “I’ll be in debt forever” funk and into actively turning your dreams into reality. Click here to sign up.
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