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.
Benefits of the Debt Snowball
The debt snowball is not the optimal method for paying off debt. You'll pay more using the snowball approach than if you pay off the debt with the highest interest rate. However, proponents of the plan feel that the emotional impact of paying off a loan completely gives people a psychological boost that helps them pay off the next.
The debt snowball is a plan designed on emotion--not mathematics. For people who can't be motivated by looking at the whole picture and have trouble understanding how each dollar they pay down changes the amount of interest they owe, the debt snowball is an excellent way to keep people motivated. Since people who get into heavy debt probably don't have an above average financial literacy, this approach helps them get out of debt while other approaches may prove to be less motivated--even if they pay the debt off faster. The best plan for paying off debt is one that people will actually follow.
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 secured debt with a mortgage at 10% and $15,000 of credit card unsecured 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 psychological "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. However, it doesn't treat the underlying cause of most people's debt--the tendency to act emotionally instead of rationally. A better approach would be to teach people to see the total financial impact of each dollar they pay down on debt so they can be motivated from a position of financial understanding instead of just looking at the number of bills that arrive in the mail each month.