There is a secret war going on in the personal finance blogosphere. No one talks about it openly, but it the battles break out everywhere. No blog post is safe! No blog post about “Debt Snowballing,” anyway.
If you don’t know the Debt Snowball Theory, it goes like this: in order to pay off all your debts, you rank them all up. You make the minimum payments on all of them each month, and you throw every extra cent you have at the debt ranked highest, until it’s paid off. Then, you “snowball” your payments for that debt into the next highest ranked debt, and continue on down the line.
The war is over how these debts should be ranked. There are two theories, each with valid points, which is why the war will never end.
Theory #1: High Interest – Rank your debts by interest rate, highest to lowest, and pay off the highest interest rate debts first.
Pro: Math-wise, this one wins. You’ll spend less money over time on interest this way.
Con: Your highest interest debts may also be your highest balances, meaning it might be a long time before you actually pay off that first debt. This can discourage some people, making them give up before they even pay off the first debt.
Theory #2: Low Balance (The Dave Ramsey Theory) – Rank your debts by balance, lowest to highest, and pay off the lowest balance debts first.
Pro: It won’t be long before your first debt is paid off, giving you an awesome sense of accomplishment, and encouraging you to continue on.
Con: Math wise, you lose, because you’ll probably pay more in interest this way.
Of course you want to know where I stand in this war. Look, people, I’m a math girl. I love numbers and data. So I’m in the “High Interest” army. But I certainly recognize the benefits of the “other side,” and I’m not going to knock anyone for going that way. In fact, if I had a really low balance debt, I’d probably pay it off first as well, to get it off my mind.
Theory #3: The Annoyance Ranking
I promised you an alternate theory, and here it is: Rank your debts in the order that they annoy you to have to pay, from “most annoying” to “least annoying,” and pay off the annoying ones first. The idea is that when the bills come, there are some bills that make you groan and moan more than others.
Let’s take The Boyfriend for example. He has two debts: his car loan, and his credit card debt. The Boyfriend loves his car to pieces, and doesn’t really mind making his loan payments every month. But his credit card? He hates it with a fiery passion. He curses it while shaking his fist up at the sky.
Basically, his credit card debt annoys the crap out of him. So, accord to my Annoyance Debt Snowball Plan, he should pay that one off first.
Why is this a good plan? Because, like the “Low Balance” theory, it plays to your human psychology. The top debts are making you more unhappy than the bottom debts, so pay them off first. Also, since you’re more likely to be annoyed by high interest debts than low interest debts, it takes the “High Interest” theory into account as well.
This theory is also good for when you have personal debts, especially family debts. These debts may be low balance and low interest, which would normally rank low in a debt snowball. But you probably feel a large amount of guilt over these debts, which would make them annoying. Putting them at the top of the ranking, and paying them first, will help improve your family relations, and perhaps prevent you from being shot in both kneecaps and lit on fire.
Be rid of debts that make you unhappy.
Math usually works since high interest debts are more likely to be more annoying.
Math might not work, may end up paying more interest.
Feel free to add more “pros and cons” in the comments if you think of any!
JW Thornhill says
I posted a very similar question on a financial forum.
My wife and I are debating this topic and normally she gets whatever she wants. Her preferred theory is Theory #1 – Highest Interest Rate to Lowest. I’m not convinced that this theory is the best yet because, I’m a big Dave Ramsey fan. But, I’m slowly leaning towards it.
But, we have to make a decision soon, because by the end of this month we will have our baby emergency fund finished and then finally some extra income to apply towards a snowball.
Finance Guy says
I don’t understand why this is such a discussion or battle that rages.
Snowball payments should be made by a hypothetical cost after X months or years, on interest weighted balances (you can flip the name too)
ie. You have 3 loans
(1) $5000 @ 2.5%
(2) $1000 @ 10%
(3) $2500 @ 5%
Consider compounding for 12 months and assuming minimum payments (of say 3% of balance).
After 12 months, the interest accrued is $107.49, $88.90, and $108.68 respectively. Thus, this is an example where neither of the two methods would have chosen the best.
Essentially, you need to consider the compound nature of interest with balance. The easiest way to guesstimate is to multiple APR by $ owed. The highest value is then the first to pay off.
However, a more accurate method, is to consider compounding. Thus, it would be:
$Owed * (APR/12+1)^(10)
The 10 is arbitrary, and represents the value after 10 months compounded. You can use different month numbers, but it will give you a good estimate.
Kevin Durette says
Finance Guy, you’re correct that BOTH the balance and the interest rate affect the TOTAL monthly interest. However, we’re not talking about the totals; we’re talking about the marginal benefit of allocating a fixed amount of extra money you have left over after you’ve made all the minimum payments. If you have a fixed amount of money to pay toward debts, we call these various methods “snowball” methods because as your minimum payments decrease, your extra payments increase. We want to maximize how much of our money goes straight to the principal and maximize how quickly those minimum payments go down by minimizing the amount of interest we need to pay NEXT month.
Let’s get more concrete. If I make all the minimum monthly payments on the three loans you’ve mentioned, I might have $100 left over to allocate to one of the three debts. If I allocate that $100 to debt 1, I’ll save $0.21 in next month’s interest. If I put it into debt 2, that savings is $0.83. On debt 3, that savings is $0.42. Only the interest rate affects which debt makes the most sense to pay now, not the current balance.
If the theory isn’t intuitive, try amortizing each scenario to see it with the numbers.
Kevin L. Durette
Given that one of the biggest issues facing people trying to get out of debt is psychological, it makes sense to employ Ramsey’s theory on it, lowest balance first, to give you the sense of accomplishment as you watch accounts close faster.
While I agree that the method Finance Guy mentions and method #1 are both better for saving on the interest in the long run, if you don’t stay motivated to eliminate debt, neither of those two are going to save you anything anyways.
Just my .02.
If you leave the debt you’re most comfortable with until last, you’re a lot less likely to actually become debt free.
That’s a good point, but couldn’t the same thing be said of any of “Low Balance?” Once you pay off one debt, the next debt has a higher balance, which is more discouraging.
None of these are “one size fits all.” I think each person is capable of looking at their own situation and knowing what will work best for them. Also, it’s not like you’re not allowed to change mid-game, right?
I love the new, alternate theory. It fits nicely with kind of an over-arching principle I have for some of these topics. I think, regardless of Dave Ramsey, Suze Orman, or math, you should just do what is most comfortable and most effective for you. Stephanie says it exactly, “None of these are ‘one size fits all.'” I second that.
Stephanie, that’s an interesting take :)Seriously though, I think ultimately it matters more that you “snowball” the debt payment by throwing every cent you have at it, than exactly which method you choose.
Finance guy: I think you have a flaw in your argument. Say, after making all the minimum payments, I have an additional $100. If I pay that amount to loan 1, I reduce the total interest paid by $2.5, by paying loan 2, I reduce the total interest paid by $10 and by paying loan 3, I reduce the total interest paid by $5. So rather than look at which loan accrues the highest interest in a year, you need to look at which one you can impact the most. In this case, it is clearly loan 2, which is the highest interest loan, or method 1. I dont see how the compounding argument comes into play here, since not making the the payment on loan 2 will mean, you will pay 10% compound interest on that $10 you could have avoided!!
Joan T says
Here is method # 4. Pick the bill that has a fixed high payment and yet the total is rather small(not your largest) In paying this off first your snowball will grow much quicker, psychologically this will encourage you to go on. ( My smallest balance has a payment of $!7 and my highest interest balance is $,10,900. the intermediate one I am working on has a balance of $2500 and a fixed payment of $140.. I will have this paid off in 7 more months and then will have a much larger amount for the next one. ) I decide on my method as I go. I have already switched from the highest interest!!!)Smiles and I love this discussion as I thought I was the only one trying to decide.
Usually when I read about money, I am not a very happy camper! It was nice to get a good laugh for once! 🙂 Whatever method you choose, make sure you snowball until you are out of debt… 🙂
Pappy Blue Ribs says
What is this so-called “debt” that everyone keeps talking about?
I blieve small steps lead to big thngs. The fact that you are paying anything, big or small, high interest rate or low, is a step in the right direction.
I love the annoyance theory! Currently I’m paying off my $600 Dell bill (lowest balance). Even though most of it is at 0%, it really torkes me off that they have $112 worth of charges at 24%. So – in that case it’s the most annoying and the one I’m going to pay off first. Then will be my next highest APR – also a lower balance.
rob in madrid says
Reader number 137
I work on the principal of getting rid of payments.
Alternative is to get rid of CC firsts as you can make extra payments anytime you have a bit of spare cash
Mrs. Micah says
We’re doing the higher-interest and most-annoying simultaneously. Because as fellow math-minded folks, Mr. Micah and I couldn’t stand the high interest 30% (!!!) on his credit card. So that’s paid off and we won’t put more on it.
While Trent’s right that this may not work for everyone because they might get too comfortable, it’ll at least get them down to one debt. And if they’re motivated to pay off debt, they’ll do it, IMO.
The theory that you shared may help alot of people. But I want to know more about it. I think there are missing things.
I’ve been debating which theory to apply as loans 1 &2 (towards a home purchase) are against my 401K and don’t affect my credit history. Loan 3 is a student loan and has the highest payment relative to the amt owed. Loan 4 ,a personal loan borrowed to clear up debt to secure the mortgage, has a high interest rate and a high annoyance factor. Also annoying, Loan 5, a credit card that’s used to gap my income shortfall. And 6, another student loan on a graduated payment plan that’s set to readjust to a higher payment next year. In addition to the debts listed I have a motgage (100K) and home improvement loan (20K).
I’m leaning towards knocking off #3 first, opening a credit card ( 0% APR /12mo) to transfer the balance of #4. But if I pay off #1 first I can reborrow the money to put towards #4 ( at a lower interest). Any thoughts?
1.$1400 $60 5.95%
2.$1500 $30 5.95%
3.$1800 $120 5%
4.$3300 $150 15%
5.$4000 $60 12%
6.$15000 $113 7.8%
First time visitor, stumbled it (thumbs up!). Can’t believe I haven’t come across your site yet. LOVE the layout! RSS’d up! As far as the post, no kidding. I paid off the last of my credit cards last year, and it is nice to be out. I used a 4th method. I got more money than I owed on my credit cards (raise) and then I paid them off and didn’t rack them up again.
Snowballing debt payments means to transfer credit card debt from a high interest rate card to a low interest rate card. By doing this you pay a greater amount of money towards the balance and less interest on debt.
No one mentioned the key actor in eliminating debt. That is of course to avoid creating additional debt. The method I employ is this: I want to be out of debt by the time I am 49. That means that I pay a fixed amount to each bill and never lower it. Then I focus extra earnings (i.e. 1/2 of raises to THE SMALLEST DEBT. Then I take the 1/4 and increase my 401k.The rest is spending money. I also pick up side work and place that money in an emergency fund. That way I do not use credit if car needs repairs. I also calculate my tax refunds into this plan, I have my debt (195,000) being paid off in 2014. But the main debt will be gone by 2011 with 3 additional years to pay the house off.
I like the most annoying debt plan because I agree that the personal debts have the most amount of guilt attached to them and guilt is the lowest vibrational energy of all the emotions so I personally vote for this theory for this reason.
Any of the snowball theories are good ones, depending on the cardholder’s psychology. The underlying issue is that it is all too easy for the credit card companies to find an excuse to jack up rates (or to not lower them) in to 20’s and even 30+ % APR and then the cardowner is placed in inescapable debt.
Remember, paying down your debts based on balance can have other benefits. For example, let’s say you have:
75,000 in student loans
15,000 in auto loan
3,500 in credit cards
For me, it would make sense to get rid of the low balance loan to free up that monthly payment, then attack the car loan, regardless of interest rates. This will free up a substantial amount of money from MANDATORY payments each month. This money can, of course, be snowballed into the student loan BUT during hard times — loss of job, illness, reduced income — more money is available for basic living expenses, while still making minimum payments. Chances of increasing debt again are reduced since there are fewer overall required payments.
Nice site.the theories what you have given is really going to help a large number of people who have to pay big debt.
LOVE the layout!This is one of the most interesting sites i really like.
Damon Day says
I have been lurking (as they say) on your blog for a few months now. Thought I would weigh in on this.
The reality is this secret war will never be won or decided because obviously different methods are better for different people and situations. I of course side with you and go for the high rates first because that just makes sense to me. However, in some cases if you have some nagging, or family debts, you might want to knock those out first, or maybe some really small store cards that it would feel good just to check them off the list.
Ultimately I actually think a combination of the three strategies will work the best for most people.
Great post though, and I liked your angle on the “secret war” 🙂
Another factor is the mental energy expended when you’re really in debt and juggling a number of cards. You really have to watch your credit card lenders (especially these days) and look at every inch of your credit card statements. The more bills you’re juggling, the higher chance of making a mistake, and as we all know, making the tiniest mistake on a credit card payment can be expensive.
So I am paying our smallest balance first, even though it’s not one of the highest APRs, because then we can close that card and it will be one less bill to deal with. Our goal is not only to strengthen our finances but also to simplify them.
Since my May 7,2008 post I am now down from 195,000 to 161,000 and counting. Its a hard road and a lot of sacrifices. The main factor is that with the recession all bills keep going up. Everything from Comcast (120.00 to now 163.00), utility bills will be going up by at least 40% when rate caps come off, food prices shot up 32% and I haven’t got a raise or cost of living for over a year. Boy its slow going but I am sticking to it.
Rob From Debt Relief USA says
We’ve been teaching the snowball method for years to our members without problems. The approach instills self confidence and is more likely to succeed, as once the lowest debt is paid off the extra money that is then available can be used to pay off the next smallest debt.
I completely agree with Theory #2: Low Balance!
That effect what it gives to me is skyrocketing!
I managed to pay off my smallest debt and that feels skyrocket! I am confident now that I can repay the others, too!
I have just cleared my next debt! Yeaah!!!
Remo Obertello says
The basic premise behind debt reduction is that you control your financial health rather than debt controlling you. Credit cards and personal loans have high interest rates. There are two options for consideration. A loan with single-digit interest, catering to poor credit and allowing balance transfers can help. The other option is for you to increase income. Either one lowers or eliminates monthly payments significantly.
It’s all about the interest rate!With ainyhntg in money, I think it’s more important to look at things numerically, rather than doing what feels good.You can have a series of victories that feel great, but don’t get you anywhere. Saving $10 a week might feel great, but it won’t have nearly the impact of putting $40 a month into an IRA.Although I would treat the Best Buy debt as being 20% interest now, beacuse if you’re even one day late, you’ll have to pay interest on the full amount, not just what’s left.
Debt Snowball is a psychological game that involves knocking down targets (debts) and enjoying the “win” associated with each victory. While I prefer the debt snowball, any method will work. The shameful act in paying down debt is delaying the start – I say quit thinking about the best method, and pick one! Get started, as the interest clock is consuming you. The only correct answer is to get rid of debt for ever!!