The snow-debt method is a debt reduction strategy, in which a person who owes more than one account will pay the account starting with the smallest balance first, while paying the minimum payment on a larger debt. As soon as the smallest debt is paid off, one proceeds to the next small debt slightly larger on top of it, so on and so on, gradually progresses to the larger one later. This method is sometimes contrary to the method of debt buildup, also called "the method of debt avalanche", in which the person pays the account with the highest interest rate first.
The debt-snowball method is most often applied to pay revolving credits - like credit cards. With this method, extra money is dedicated to paying the debt with the smallest amount owed.
Video Debt-snowball method
Methodology
The basic steps in the method of snowball debt are as follows:
- List all debts in ascending order from the smallest to largest balance. This is the most characteristic feature of this method, since the order is determined by the amount owed, not the interest rate charged. However, if two debts are so close in the amount owed, then the debt with higher interest rates will be moved up in the list.
- Commit to paying the minimum payment on each debt.
- Determine how much additional can be applied to the smallest debt.
- Pay the minimum payment plus the extra amount to the smallest debt until it is paid off. Note that some lenders (mortgage lenders, car companies) will apply an extra amount for subsequent payments; In order for methods to work the lenders need to be contacted and informed that additional payments should go directly to a substantial reduction. Credit cards usually apply all payments during the current cycle.
- Once the debt is paid in full, add the old minimum payment (plus the additional amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new amount to pay the second smallest debt.
- Repeat until all debts are paid in full.
Theoretically, when the last debt is reached, the additional amount paid for the larger debt will grow quickly, similar to a snowball rolling down a hill that collects more snow (hence its name).
This theory works as much as possible on human psychology; by paying smaller debts first, individuals, spouses, or families see fewer bills as more individual debt is paid off, thereby providing continuous positive feedback about their progress toward the elimination of their debt.
A first home mortgage is generally not included in a debt snowball, but instead paid off as part of a larger person's financial plan. For example, many financial plans pay off home mortgages in the next step, along with other debt equivalent to or greater than half of one's annual salary.
The issue of whether a person should contribute to a pension during the debt reduction process is a matter of dispute amongst supporters of this method:
- Some argue that all contributions should be stopped during a debt snowball, thus freeing up more money to pay for debt snowball.
- Others deny this practice, for the reason that the combined interest cost is greater than the profit of paying off the debt.
- Some compromise by stating that pension contributions should be reduced only to the minimum amount to be matched with an employee, but not completely eliminated.
- Many financial and wealth experts teach that the retirement of this pension contribution should last no more than two years.
Maps Debt-snowball method
Example
An example of the snowball-ball method in action is shown below. (This example does not add in monthly monthly interest from credit cards and loans make higher amounts of balance and payout time.)
Someone has the amount of debt and the following additional funds available to pay off debt (registered debt with the smallest first balance, as recommended by method):
- Credit Card A - $ 250 balance - minimum $ 25/month
- Credit Card B - balance $ 500 - minimum $ 26/month
- Car payment - $ 2500 balance - minimum $ 150/month
- Loans - $ 5000 balance - minimum $ 200/month
- The person has an additional $ 100/month that can be used for debt repayment.
The first two months - under the snowball-debt method, payments will be made to the following creditors:
- Credit Card A - $ 125 ($ 25/minimum $ 100 additional month available)
- Credit Card B - at least $ 26/month
- Car payments - minimum $ 150/month
- Loans - minimum $ 200/month
The balance of the third month (assuming the person is not added to the balance, which will defeat the purpose of debt reduction) - Credit Card A will be paid in full, and the remaining balance is as follows:
- Credit Card B - $ 448
- Car payment - $ 2200
- Loans - $ 4600
Third month payment - person will then take $ 125 previously used to pay Credit Card A and apply it as additional payment to Credit Card B balance, which will make payments for the next three months as follows:
- Credit Card B - $ 151 ($ 26/month minimum additional $ 125 available)
- Car Payments - minimum $ 150/month
- Loans - minimum $ 200/month
Three more months (total six) - Credit Card B will be paid in full (last payment will be $ 146), and the remaining balance is as follows:
- Car Payments - $ 1,750
- Loans - $ 4000
Then the person will take $ 151 that was previously used to pay Credit Card A & amp; B and apply it as an additional payment to your car loan balance, which will make the following payments:
- Car Payments - $ 301 ($ 150/month minimum additional $ 151 available)
- Loans - minimum $ 200/month
It takes six months to pay for a car loan (last payment is $ 240), then the person will make a $ 501/month payment on the loan (which will have $ 2800 balance) for six months (with the last payment of $ 234).
So in 17 months people have paid four loans, with two of them paid in just five months and three in one year.
Benefits
The main benefit of the smallest balance plan is the psychological benefit of seeing quicker results, where the debtor sees a reduction in both the number of creditors owed (and, thus, the amount of invoices received) and the amounts paid to each creditor.
Pension contributions should begin after your expected investment returns are higher than the next highest interest rate (generally 8% for a balanced portfolio).
In a 2012 study by Kellogg School of Management from Northwestern, the researchers found that "consumers who handle small balances are more likely first to eliminate their debt overall" rather than trying to pay high interest rate balances first.
A 2016 study at Harvard Business Review came to the same conclusion.
Criticism
People with more financial discipline can advance faster by paying off credit cards and borrowing at higher interest rates first. This will minimize the cost of becoming debt free faster than the smallest balance approach.
Dave Ramsey, a supporter of the debt-snowball method, recognizes that mathematical analysis and interest rests on paying the highest interest debt first; However, based on his experience, Ramsey states that personal finance is "20 percent of head knowledge and 80 percent behavior" and that people who try to reduce debt require "quick wins" (that is, pay off the smallest debt) in order to stay motivated against debt reduction.
Research
Research decision making has revealed that the debt-snowball method is a very common approach to managing some debt, even when larger debt has a higher interest rate. Amar, Ariely, Ayal, Cryder, and Rick (2011) observed this trend in overseas consumer surveys and in incentive-backed experiments. Amar et al. (2011) found that people naturally use the snowball method, paying off small debts first, and this reflects their financial results negatively as they continue to pay off debt in an inefficient way. Moreover, Amar et al. (2011) found that limiting participants' ability to pay off small debts actually helped them to reduce their overall debt faster, by refocusing their attention on paying off high-interest debt. The natural tendency to pay off the first small debt (which Amar et al called "debt account evasion") has been attributed to the attractiveness of reaching a near-completion goal and the tendency for some losses (eg, debt) to be more miserable than an equivalent total loss of value.
See also
- Personal finance
- Consumer financing
References
External links
http://penniesanddollars.com/no-snowball-method/
Source of the article : Wikipedia
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