Snowball Your Payments
“’Snowball method,’ you say? What kind of name is that?” you may be wondering. In this article, we’re going to examine the most powerful technique for getting out of debt sooner and minimizing the interest you pay. Hopefully by the end of the article, you’ll understand why we call it the “snowball method.” And no, it doesn’t involve the white powdery stuff.
Credit card companies devised the minimum payment to charge you more interest, plain and simple. For many high-interest cards, the minimum payment barely covers the monthly finance charges! That’s why it’s critical that you pay more than the minimum amount due each month. To keep things simple, from here on we will refer to the extra payment above the minimum as the “snowball payment.”
Now here’s where the real power of the snowball method comes into play. When you completely pay off a credit card, redirect your usual monthly payment for that card to another one. Each time you pay off a credit card, your payment to the next card increases. You do this until finally you are left with only one card, which receives your entire monthly payment. You pay the same total amount every month the entire time, but the payments to each individual credit card builds up, or snowballs, as time goes on. To see how this works, let’s look at a real-world example:
Alice has three credit cards: Card A, Card B, and Card C. Her minimum payments for the three cards are $100, $200 and $300 respectively, making her total minimum due each month $600. Alice knows that it’s important to pay more than the minimum. She sets aside $1,000 every month to pay down her debts. After Alice deducts the minimum payments, she still has $400 of her $1,000 left to use. So Alice sends $500 each month to Card A, which includes the $100 minimum and her remaining $400 snowball payment. Since Alice channels all that extra money to Card A, she pays off that card long before the other two. Once she pays off Card A, she takes the $500 per month she was paying to Card A and tacks it onto her payment for Card B. So now Alice pays $700 per month to Card B and $300 per month to Card C. At $700 a month, Card B gets paid off in no time. Now that Card B is paid off, Alice sends the entire $1,000 payment to Card C.
As you can see, Alice’s payments “snowballed” as she neared the end of her debt. However, paying more than the minimum each month and snowballing your payments is only part of the story. To make the most of your money, you must intelligently choose which credit card to pay off first. You might be tempted to divide your snowball payments evenly between all your cards. While this may seem like a good idea, it could needlessly cost you thousands of dollars in interest.
You should always send your snowball payment to the credit card or loan that charges the highest interest rate.
Here’s why. Think of interest rates as the cost of borrowing money over time – the higher the interest rate, the more expensive the loan. You save the most money by paying off the most expensive credit card or loan first. This means you should focus all of your snowball payments on the account with the highest interest rate. Pay the minimum on everything else, but pay as much as you can above the minimum on the card or loan with the highest interest rate.
If you’re having difficulty understanding the reasoning behind focusing your payments on the highest interest rate account, consider this analogy. Imagine that you are investing your money in three companies. Company A pays a 5% return, Company B pays a 10% return, and Company C pays a 15% return. All the returns are guaranteed; you can’t lose any money with any of them. You must invest a certain minimum in each company, but anything above those minimums you can invest as you please. Would you divide your extra investment evenly between all of them? Would you send it all to Company A at 5%? Of course not! You would send every bit you could to Company C at 15%, and as little as possible to the other two. The same principle applies to credit cards. When you pay off a card charging you 15% interest, it is like getting a 15% percent return on your money.
Some repayment methods suggest sending your snowball payment to the card with the lowest balance. While this may make it feel like you’re paying off your debts more quickly, the psychological effect doesn’t correspond to reality. The reality is that paying off the highest-rate card, not the highest-balance card, saves you the most money and gets you out of debt sooner.
Try it yourself
Enough with the theory. We’ve set up a convenient snowball payment calculator for you to try out this technique yourself. Just select how many cards you have, enter your balances and interest rates, and the calculator will tell you quickly how you should divide your payments.
