Debt Snowball
From Debt Free Dude
The idea behind a "Debt Snowball" is to help give people a way to get out of debt that is psychologically fulfilling. This is done by paying off your smallest debt first--regardless of the interest rate. The momentum and excitement of seeing debts disappear helps encourage you to continue the process. You get to see a lot of progress early on as debts are paid off.
To do a Debt Snowball, you pay all of your payments and then put any money left over toward your smallest debt. Once that debt is paid off, you do the same thing with the next smallest debt and work your way up to the largest loans.
[edit] Criticism of Debt Snowball
The Debt Snowball is not an optimal plan from a financial point of view. If you simply pay off your smallest debt first, you may end up paying off the lower interest loans first while saving the highest interest loans for the end. This means you will be paying money in interest that could be put toward the principle if you start with the loans with the highest interest.
The optimal strategy is to start by paying as much money as possible on your debt with the highest rate of interest. As the loan is paid off, the amount you pay on interest goes down which frees up more money that can be used to further lower the principle.
For example, assume Jim has $10,000 of debt at 10% and $15,000 of debt at 15%. If over the course of a year he pays an extra $5,000 on the $10,000 loan the interest on that loan for the next year will be $500 and the interest on the larger loan will be $2250 for a total of $2750. Now lets assume that he put the extra $5,000 into the loan with the higher interest rate. The $10,000 of debt will require interest of $1000 and the $15,000 loan (now reduced to $10,000) will require $1,500 in interest. The total under the second scenario is $2,500.
In the second scenario, the interest for the year was reduced by an addition $250 by paying of the higher interest loan first. If this additional $250 were put against the principle on the loan it would further reduce the amount paid on interest. So in effect, paying off higher interest loans instead of the smaller loans first produces more of a "snowball" effect.
The Debt Snowball is a physiological trick to help people with poor financial discipline get out of debt. However, since many of the reasons people get deep into debt is because of poor financial discipline, it can potentially be a good approach--especially for people who won't stick with any other type of process.
