Credit cards may be a blessing and lifesaver if used properly. Unfortunately they are also a source of personal financial problems. Nowadays, an American family carries, on average, $3,300 in debt per credit card and owns just over 3 cards. Even in the current economic situation, which is rosier than few years ago, it is still quite a battle to become debt free.
What is a snowball method of debt reduction?
Snowball Method refers to eliminating your smallest debt first. You determine what are your outstanding obligations, which may be a mix of credit cards, student loans, car loan, mortgage, etc, and focusing on paying off the one with the smallest amount first. At the same time, you continue making minimum or required payments on your other obligations to avoid default on any of them.
This method assumes that besides having enough money to make payments on all your debt, you also have additional funds you can deploy to debt reduction.
So how does it work?
To make this example uncomplicated, assume you have 3 credit cards and no other outstanding debt. Let’s call them Debt #1, Debt #2, and Debt #3. Debt #1 has a balance of $500, Debt #2 balance of $550, and Debt #3 balance of $600. Minimum payments are $20, $22, and $24 (this may vary from one account to another). To make this work you have to have additional funds available to actually bring the balances down. Let’s say you have $100 to your disposition.
First month you make a payment of $120 to Debt #1, $22 to Debt #2, and $24 to Debt #3. As you can see, it will take less than 5 months to eliminate Debt #1 entirely. At that point, you would pay $144 to Debt #2 ($22 of minimum payment + $100 of extra funds + $20 that used to service Debt #1) and $24 for Debt #3. Follow the same logic until Debt #2 is eliminated. At that point you channel all available funds to the last remaining debt.
What are the other options?
There are valid arguments that this method is flawed and that you should first target debt with the highest interest rate. In principle, that is correct, you should first pay off the most expensive obligations, but in practice it is not always the case.
The reason Snowball Method has been popularized and accepted is that it provides a necessary encouragement and sense of achievement. Paying off debt is often a personal battle, there is no one there to cheer for you, and so by eliminating the smallest debt first, it’s like picking small battles first, winning them and then facing more challenging situations. It is often an important moral boost and a sense that it can actually be done.
It also helps to focus on a task of becoming debt free. Having 5 credit cards to pay off may seem a Herculean task and you may not even attempt doing it, feeling powerless and seeing only a miniscule progress. But when you pick a specific credit card you can better manage debt servicing and track the actual progress. You don’t need monitor precisely what’s happening to other balances so long you make minimum payments. What you are able to appreciate is the constant progress with the one card you pick and realize it is possible to pay it off. Once you’re done with that one, the sense of encouragement helps to eliminate debt # 2 especially that the funds you used to apply to debt #1 can be directed towards debt # 2 in its entirety, therefore making a much bigger overall payment. Those ever growing payments towards debt elimination are like a rolling snowball that gains size and speed as it moves forward.