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The Backwards Logic Behind the Debt Snowball Method
Would it make sense to state that some of the best debt repayment advice is the wrong advice?
It seems strange, however it is often true. Many financial planners and other financial experts will advocate paying off your debt by tackling the lowest-balance credit card first... regardless of rate.
This is technique is known as the debt snowball method.
The debt snowball method makes sense for psychological reasons because it allows the indebted borrower to feel a sense of accomplishment once he or she repays that smaller debt in full.
This sense of accomplishment keeps them focussed on their goal of getting out of debt.
However, the debt snowball method does not make proper financial sense because it ignores the rates and charges being paid on all credit, including the lower-balance credit card or debt that you pay first.
In financial terms, it always makes sense to target the debt with the highest rate because once that debt is repaid, every dollar you have left can now accelerate the repayment period on your other debt.
For example, if you have a credit card with $4,000 owing and charging a rate of 19% and another card owing for $15,000 at a rate of 24%, you will be paying $900 in additional interest to carry the $15,000 for a year while you repay the smaller debt for $4,000.
In other words, the debt snowball method is expensive and ineffective in terms of total costs.
Looking at this another way, would you pay 24% to lock in all of the above debt simply for the sake of being able to make a single payment?
Probably not because cost is normally a factor in making rational decisions.
Yet this does not seem to be the case when it comes to the debt snowball effect, which asks borrowers to ignore cost and fundamental principles of financial planning and pay off lower balance debt ahead of all else, regardless of cost.
The costs may be irrelevant, however if the borrower is able to get out of debt when it all said and done.
There is a lot of benefit to being able to achieve the goal of repaying one credit card or one loan... the trick is to stay motivated when repaying the higher balance debt.
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A person who offers to assign an asset as security (e.g. real estate) under a mortgage loan contract. The lender (mortgagee) holds the legal ownership of the security until the loan is repaid and the mortgage is discharged.