A couple of months ago I thought the snowballing method was just taking every spare penny which was not being used up in your budget and throwing it at one of your debts, like a snowball fight! It is a bit more strategic than just randomly throwing extra money on whatever debt.
Snowballing has its benefits, but in the grand scheme of tangible finances it may not be the best way to go about conquering your debt. The way I see it is snowballing is focused on paying off your smallest debt first and then moving onto the next smallest debt and so forth, until all which is left is the largest debt. Each time a debt amount is paid off you would then take the payment you would normally put towards the smallest debt and add it to the payment for the next smallest debt. Interest rates are not applicable in the snowballing method, and it may feel really good to have one debt completely gone, BUT in the meanwhile you could be accruing MORE debt based on what the interest rate is.
Shopaholic Sally has $40,000 in debt and between all of her expenses she is paying a total of $950.00 a month towards her debt.
The breakdown of Sally’s debt and payments are below:
Visa Card $15,000 at 20% Interest (Payment $350 a month)
Line of Credit $2,500 at 1.5% Interest (Payment $50 a month)
Luxury Shop’s Card $5,000 at 22% Interest (Payment $125 a month)
Master Card $4,000 at 10% Interest (Payment $25 a month)
Loan $13,500 at 8% (Payment $400 a month)
If Sally goes with the snowballing method she is going to go with her smallest amount of debt (which is her line of credit at $2,500 which also has the lowest interest rate at 1.5%). After paying all of her other bills, any extra money she may have she will put on the line of credit until it reaches a balance of zero. Gosh, just typing up this faux scenario is giving me anxiety for Shopaholic Sally!
Line of Credit is Zero – Hooray Sally, now don’t go blowing your money on celebrating this accomplishment. Sally then eyeballs her remaining expenses and will now hit up the Master Card and snowball it with the extra $50 payment she no longer has on her line of credit, her payments will then be $75 a month or if Sally is smart and she receives birthday money, or a bonus she will put all extra money on her Master Card.
Finally she will move onto the Luxury Shop card which Sally maxed out on her first purchase being a classic black quilted Coco Chanel bag. No, I do not own anything Chanel besides some make up. Since she has been chipping away at her smaller debts the 22% interest rate on her Luxury Shop card has been accruing more debt. Her luxury purse is going to cost her a lot more than $5,000.
This is where the banks sucker punch you. If Sally wasn’t putting extra on her Luxury Shop card and only making the minimum payment which is 2.5% of the $5,000. It would take her over 300 months to pay off her purse and the total interest paid would be over $11,900 IN ADDITION of the $5,000.
Sally could be using that money for a down payment on a house, which is also an investment where she should gain profit in the end. Instead she was donating her money to a bank instead.
High interest rate credit cards should only be used by the very responsible shopper. Most credit cards with a high interest rate will entice you with perks such as air miles, points towards a brand, earning money towards buying a car, and these are great incentives, and great rewards IF and ONLY IF you are paying the balance off at the end of each month, otherwise you’re just giving your money away to the bank.
My credit card is paid off, but I have a lower interest rate on my credit card, because until I can prove to myself that I can be responsible and pay off the monthly balance, I am not taking the risk of a high interest rate.
Once Sally pays off her Luxury Shop card, she then moves onto her loan and then Visa Card which has the second highest interest rate of 20%.
That is snowballing, paying one small debt off and then taking the extra money saved from not having to pay it and moving onto the next smallest debt till it is gone and so forth. It is rewarding to the degree of crossing things off of a list, but most financial experts from what I read would not recommend this method, but something more strategic and firstly tackling those high interest rates first.
A more effective strategy in attacking debt is a method called “Stacking Debt”, which I will explain in my next blog.
And remember fellow shopaholics who are trying to pay off consumer debt…