Traditionally, borrowers have preferred to repay the loan with the highest interest rates first, while making minimum payments on the other loans. This method helps in getting rid of the loan that charges high interest rates first up. As a result, you avoid having to pay hundreds of dollars as interest over the life of the loan.
In his blog, Dave Ramsey suggests a different approach. His method involves:
- Making a list of all your debts, sorted in ascending order, with the debt having the smallest balance appearing at the top of the list
- Paying the minimum amounts due on all the debts in the list, except for the debt with the smallest balance
- Ascertaining the maximum amount you can contribute each month toward becoming debt free
- Paying this amount to the debt with the smallest balance
- Applying this method for repaying the debt with the next lowest balance, after you’ve repaid the debt with the smallest balance and,
- Sticking to this repayment method until you have repaid all your loans
This method, called the Debt Snowball Method, focuses entirely on the balance of a debt rather than its interest rates.
In an example, Ramsey lists the following debts and minimum payments due:
- A medical bill worth $500 (minimum payment of $50)
- Credit card debt worth $2,500 (minimum payment of $63)
- A car loan worth $7,000 (minimum payment of $135) and,
- A student loan worth $10,000 (minimum payment of $96)
In this situation, the borrower commits to paying an additional $500 per month for becoming debt free. This is in addition to paying the minimum amount due each month.
In the first month, the borrower pays the minimum amount due on the credit card, the car loan and the student loan. Then, the borrower repays the medical bill with the $500 committed to becoming debt free and the $50 paid each month toward the medical bill. This ends the smallest debt on the list within the first month itself.
The following month, the borrower focuses on the credit card debt. This individual pays the minimum amount for the car and student loans. Then, the borrower has $613 with which to repay the credit card debt. This includes:
- The monthly commitment for becoming debt free i.e. $500
- The freed-up minimum amount spent earlier on the medical bill i.e. $50 and,
- The minimum amount payable for the credit card i.e. $63
The borrower pays $613 per month to the credit card company. Within four months, the borrower attains freedom from credit card debt as well.
The borrower can now focus on paying back $748 each month for the car loan. This includes $613 (the amount paid each month to the credit card company) and $135 (the minimum amount payable for the car loan). Applying the same strategy, the borrower takes 10 months to repay the car loan.
Similarly, the borrower has the ability to repay $844 ($748 + $96) per month toward the student loan. Within 12 months, the borrower repays the student loan and gains financial freedom from debt by repaying $20,000 in debt within 27 months.
Ramsey cites the example of a small snowball that becomes a snow boulder when a person rolls it down an incline. This method adopts a similar strategy. By clearing off the smaller debts, it gives the borrower a shot in the arm each time the person repays a debt. It also transforms a small sum ($500 in this case) into a bigger amount with each repaid debt. This gives the borrower greater bandwidth (or momentum) for repaying the other existing debts faster.
He mentions that you could clear the debts with higher interest rates and achieve the same results too. However, the volume of the debt would only show declining balances for several months on end. As a result, the borrower could become frustrated and end up quitting the plan midway.
However, the Snowball Method has its downside too. In her post, Anisha Sekar cites an example of a person with:
- An auto loan worth $5,000 (three percent interest)
- A student loan worth $8,000 (eight percent interest) and,
- Credit card debt worth $15,000 (18 percent interest)
This individual has to pay $100 as minimum payment for each of the three debts. Sekar mentions that by following the Snowball Method, the borrower would become debt free in 101 months, after paying $22,613 in interest. The interest paid would be almost the same as the total amount due. In addition, the borrower would also take about 18 months for closing the auto loan. This would hardly provide any psychological boost either.
In contrast, Sekar writes that the conventional method of repaying the debt with the highest interest rate first would enable the borrower to become debt free within 86 months. That too, by paying only $14,650 in interest.
In a separate post, Trent compared Ramsey’s Snowball Method with the method suggested by Suze Orman. Orman’s method involved:
- Determining the largest possible amount you could afford to pay for all your debt balances together
- Adding $10 to the minimum amount due for each debt per month
- Adding all the minimum amounts due for each debt in a month (along with the $10 extra for each loan)
- Calculating the difference between the figure arrived at in the first step and the figure computed in the third step
- Applying the figure arrived at in the first step to the debt with the highest interest rate (if this figure exceeds the figure computed in the third step) until you clear the first debt and,
- Repeating the process until you become debt free
Based on various calculations, Trent concluded that:
- The conventional method of repaying loans with the highest interest rate always bettered or tied with both Ramsey’s and Orman’s methods for debt repayment
- Orman’s plan was close to optimal most of the time
- Ramsey’s plan was either exactly optimal or else poor compared to Orman’s plan or the conventional plan of repaying the highest interest loans first
- However, when viewed from a purely psychological standpoint, Ramsey’s Snowball Method enables you to experience success much faster than the other two plans do
When it comes to getting out of debt, any repayment plan you make (and stick to) is worthwhile. However, evaluate which plans works best for you, as not all debt repayment plans are equal.