May 19, 2017 / by Jaqueline / irhf guide / No Comments

What is a debt snowball?

Have you tried building a small snowball, and watch it run downhill? Have you noticed that it tries to get more snow along the way, until it rolls faster, taking in more snow until it becomes as large as a boulder?

A debt reduction strategy popularly known as the debt snowball is called as such because of the same principle applied to that of a snowball. In the debt- snowball method, the borrower focuses on eliminating the smallest debts first, regardless of the interest rate. Let us examine further why it can be compared to the snowball.

Methodology

In snowballing your debt, the first step is to prepare a certain stash of money for emergency fund, then concentrate in paying off one debt at a time.

Next, you have to list down all your existing debts, starting from the smallest debt first, regardless of their interest rates. These can include personal loans, credit cards and other hire purchase agreements. However, interest may play a role when two debts have exactly the same amount, which in this case, the one with the higher interest rate should be listed first.

Then you will have to commit to paying for minimum amounts in each debt, except for the smallest one. Meanwhile, you have to determine how much extra you can spare for paying off your smallest debt. Do this until the smallest debt is paid in full.

After settling the first debt, proceed to the second smallest debt. Add the old minimum payment including any extra amount used in paying off the first debt and combine it with the second debt’s minimum payment. Repeat the process until all debts are paid in full.

Theoretically, you start small, but by carrying over the previous amounts towards paying off the larger debts, they grow quickly, just like a snowball.

Psychological Benefit

According to financial author and host Dave Ramsey, who is the proponent of the debt- snowball, snowballing your debt can help build momentum. He believes that “personal finance is 20% head knowledge and 80% behaviour”. In order to be successful in debt reduction, people need to see quick results. By noticing that the number of bills and creditors are reduced, chances are the person is more likely to stick to debt repayment.

Criticisms

Other financial experts dispute this practice, because it is considered as “mathematically incorrect”.

By delaying payments of the larger interest debts, you will only prolong the period you are in debt because of compounding interests. You will also end up paying larger amounts than if you prioritized paying for the larger interest rate debts.

Free up your cash

There are also arguments whether or not the person should halt paying in retirement contributions to free up more money for debt reduction. Some suggest that retirement contributions should not be stopped entirely, but only reduced to minimum, and this period that retirement contributions are halted should not exceed 2 years.

In addition, the debt snowball can only be effective for individuals who earn enough to meet the minimum repayment amounts. The method may cause problems if you are struggling to meet the minimum repayments. Before you decide that it’s right for you, you need to assess your income and your personality and attitude towards debt.

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