Paying Off Debt: 6 Steps to Building a Better Snowball

The “snowball method” for paying off debt isn’t something out of the movie Clerks. It is a way to organize your outstanding debt in such a way that the funds you have available for paying off debt are optimally distributed in the manner that will allow you to pay off that debt quickly and cheaply.

There are two opposing philosophies or approaches to the snowball method. The first system was popularized by financial guru Dave Ramsey. In his own words, here is his approach to the Debt Snowball method:

List your debts in order with the smallest payoff or balance first. Do not be concerned with interest rates or terms unless two debts have similar payoffs, then list the higher interest rate debt first. Paying the little debts off first gives you quick feedback, and you are more likely to stay with the plan.

Once you have your debts listed in order, pay the minimum payment required to all the debts except for the debt on top, which should receive all the remaining funds for debt service. The value of this approach is in the small victory. By paying your debts off from smallest balance to highest, you will reach satisfaction quickly. For someone who has made debt their way of life, has made the commitment to turn over a new leaf, and requires small successes for motivation, this approach may be beneficial.

Debtor beware: If you choose the above method, you could be paying more interest than necessary for a longer time period than necessary. Simple financial calculations show that if you order your debts from highest interest rate to lowest interest rate rather than lowest balance to highest balance, and then follow the same steps outlined above, you will pay off the debt sooner and spend less on interest throughout.

The big assumption is that you will be able to focus on the larger goal of paying off the entire debt without a quick rate of successes to constantly motivate you. The higher interest rate method still sees you paying off smaller debts throughout the process, so it’s not completely without motivational cues.

This calculator is one of the best I’ve seen that illustrates this point.

Let’s assume I have three credit cards to pay off. Remember the rates stated are hypothetical for the purpose of illustration the first is a Slate from Chase Card with a $13,000 balance and an interest rate of 14.99%. The second card is an airline travel card with a $9,000 balance and an interest rate of 13%. The final card is a United MileagePlus Explorer Card with a balance of $7,000 and and APR of 7%.

Remember, this is a hypothetical example and not my personal debt situation. Here’s how to use my improved snowball, Flexo’s Debt Avalanche.

Like Dave Ramsey says, the first step is to establish an emergency fund. That’s important, but not directly related to paying off the debt, so let’s use that as our initial starting point and call it Step 0:

Debt Avalanche Step 0. Establish an emergency fund. For someone who is working on paying off debt, the optimal emergency fund should be all cash, deposited in a savings account. Savvy financial all-stars have other options available to them (like a Roth IRA or — as a matter of fact — credit) but for someone on the road to recovery, cash is the best option. Consider leaving a portion of your cash in a local bank or credit union for fast access but the bulk of the deposit should be in a high-yield savings account such as Ally Bank.

It’s good to build up several months’ worth of expenses in this fund, but once you get a foundation of $1,000 or so, don’t hesitate starting the Avalanche.

Debt Avalanche Step 1. Commit to avoiding new debt. You should not add to your credit card balances while in Avalanche mode. It would be massively counterproductive. Also, while you are paying off debt, you will be forced to live within your means. Once your debt is fully paid off, continue living below your means with cash.

If you have truly changed your approach to using credit during this time, you may safely be able to use your credit cards again to take advantage of convenience, rebates, and other special offers. But let’s not get ahead of ourselves. The goal is to eliminate credit card debt as well as the need for credit card debt. From now on, you will only spend less than you earn, only in cash.

For some people, this is a major change in philosophy or a “paradigm shift” as motivational speakers are wont to spew. Whatever you call it — Eureka, an epiphany, common sense, or Enlightenment — you have to be in the right mindset before you can be successful. For those set in their ways, this will be the most difficult step, but it must be completed before moving on to Step 2.

Debt Avalanche Step 2. Call your creditors and negotiate lower interest rates. Your credit card companies will be happy to reduce your interest rate, but in some cases, they will close your card and not allow you to make further purchases. That’s fine! You are in Avalanche mode and you have no need to use the cards again for purchases. Our example debtor was able to lower his Business Gold Rewards Card interest rate from 14.99% to 9%.

Even if you think your interest rates are already “low,” call your customer service representatives anyway. Keep going up the ranks of supervisors until someone lowers your interest rate.

Step 2a. Some time — maybe a month or two — after you negotiate, check your credit reports for free via CreditKarma.com. Verify that your credit cards didn’t provide the agencies with information that could potentially be harmful to your credit score. If a card is listed as closed, it should be listed as, “Closed at account holder’s request” or with similar terminology, not, “Closed at issuer’s request.” Dispute any incorrect information with the reporting bureaus as necessary.

Look also at the minimum payment required by each card. You should have enough cash available from income each month to meet all of your minimum payments plus some. If not, then you may have to negotiate more than just interest rates. The solution may be to consolidate your debt into one credit card, a bank loan, or a home equity line of credit. This may stretch out the time it takes to finish paying off the debt, but it is the best way to meet your monthly obligation.

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Step 2b. Take a pair of scissors and slice your cards into small pieces. For those seeking an emotional high to boost and motivate them through the process, like the small victories Dave Ramsey says are important, this may provide the same feeling and effect. Listen to Pink Floyd’s song “One of These Days I’m Going to Cut You Into Little Pieces,” which may have been written about the process of paying off debt despite the band’s claim otherwise.

Debt Avalanche Step 3. Use this calculator (with the “Interest Order” option) to determine the amount to send each card each month, and stick to this schedule without missing one payment. For fun compare the “Interest Order” option to the “Balance Order” option. With the example debt, a total of $1,000 available each month, and minimum payments of 2% of the balance on each card, the “Balance Order” option as prescribed by Dave Ramsey would cost about $500 more and take one month longer than the “Interest Order” option. That’s a shame; perhaps you could have spent that $500 on Dave Ramsey’s seminars and books. But you won’t, now that you see his plan is mathematically inefficient.

Better yet, if you want to part with an unnecessary $500, just send it to old Pink, care of the Funny Farm, Chalfont.

Debt Avalanche Step 4. Automate your payments so you don’t even have to think about them. Reduce stress, reduce agony, and increase your time on other life-enriching activities. Have your credit card deduct the appropriate amount each month directly from the checking account is directly deposited. This may be difficult if your amount changes each month, but at the very least, set up direct debit so all you have to do is click a few buttons online rather than writing a check.

When the first card is completely paid off, shift the largest amount of available cash to the second highest-balance card, still paying the minimums on the remaining debt. Lather, rinse, lather, rinse, ad finitum, or until pigs (three different ones) fly.

Debt Avalanche Step 5. Get in the groove of spending within your means by cutting back expenses. Perhaps you can think about creating a budget if your means are tight. If you want to spend more, find ways to earn more. If you haven’t already, formalize your personal finances. Grab software like Quicken or sign up or Mint and track all of your expenses, including what you spend with cash every day, and map out a formal budget.

Want support from a community of individuals in a similar situation? Start an anonymous personal finance blog and write about your journey, complete with struggles, triumphs, and more than enough melodrama to go around. (Just don’t beg people to send you money to help pay off the debt you incurred. That’s not classy.) Also check out No Credit Needed, the premier blog for eliminating debt.

Debt Avalanche Step 6. Complete your payoff and celebrate. How you choose to celebrate is up to you, but it would be a good idea to reward yourself without getting back into the credit card habit.

Taking advantage of airline miles rewards and cash back rebates is an advanced technique better undertaken by someone who has shown they can use credit responsibly and avoid late fees and interest payments while paying off their entire statement balance each month.

After you have reformed your spending ways, you may be ready to make money off of credit cards with 0% APR deals or balance transfer arbitrage, which take some discipline, perseverance, and willingness to fight to get what you want from unscrupulous credit card companies.