Dave Ramsey Debt Snowball Payoff Strategy

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Dave Ramsey is most well known for an idea known as a “debt snowball” repayment plan. The idea taps into human psychology and our desire to reduce the number of something, even if the sizes of those “somethings” vary (more on this idea this afternoon).

While it may not be the mathematically optimal strategy, and everyone agrees on this, it’s one that has seen great success over the years.

The basic premise is that you make minimum payments to all of your debts and put any extra debt repayment dollars towards your smallest debt.

As you retire debts, you take those minimum payments and apply them to the next smallest debt. In this manner your small minimum payments “snowball” so that as you near the end, your payments are much larger than the remaining minimums.

Debt Snowball Payoff Strategy

 

Example Debt Snowball

Let’s say you have five loans:

  • Student Loan : $25,000 @ 6% APR
  • Mortgage : $100,000 @ 5% APR
  • Credit Card A : $9,000 @ 19.99% APR
  • Credit Card B : $8,000 @ 19.99% APR
  • Car Loan : $5,000 @ 6% APR

First, you list all of your debts starting with the smallest balance to the largest:

  • Car Loan : $5,000 @ 6% APR
  • Credit Card B : $8,000 @ 19.99% APR
  • Credit Card A : $9,000 @ 19.99% APR
  • Student Loan : $25,000 @ 6% APR
  • Mortgage : $100,000 @ 5% APR

First, you make minimum payments on every debt so you are current and suffer no penalties, fees, or other adverse effects. If you have an extra $100 each month left over for debt repayment, you put it towards the Car loan because it’s the smallest debt.

Once you retire the car loan, take it’s minimum payment and put it towards Credit Card B. Once Credit Card B is retired, go after Credit Card A.

 

Not Optimal, but Effective

Why is the debt snowball not the optimal solution? You pay the most in interest on the higher APR debts, the credit card balances. The “best” way, as defined by paying the least in interest, is to put extra money towards Credit Card A and Credit Card B, since they have 19.99% APR interest rates.

Since you pay off the car loan first, according tot he debt snowball method, you are paying more in interest than you otherwise would have.

This afternoon, I’ll point out why this, less correct method, works better than the mathematically optimal one.

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