Quick Review: The Debt Snowball
Have you heard of the debt snowball?
It works like this: You pay the minimum payment on all of your cards/loans EXCEPT for your lowest balance card or loan. You throw as much money as you can at that particular debt until you get it down to a $0 balance. Then you take all of the money that you were paying towards that now-paid-off debt, and add it to the minimum payment of the next lowest balance card or loan.
The term “snowball” comes from the way your payments increase as time progresses.
Confused? Here’s an example of the debt snowball:
You have three credit cards.
Card 1 has a balance of $500 and a minimum payment of $15
Card 2 has a balance of $1,500 and a minimum payment of $30
Card 3 has a balance of $2,500 and a minimum payment of $30
If you followed the debt snowball, and had $250 to throw at your debt every month, here’s how your first year would look:
At the beginning of the year, you started out with 3 credit cards with a total debt balance of $4,500. After just 1 year, you now only have 1 credit card, with a paid down balance of $1,500.
BTW, to keep it simple, I didn’t factor in interest. Your payments would only match the above table if you had 3 interest-free cards. Otherwise, your balances are going to increase each month with the added interest until you pay them off.
So, remember this for later: Debt interest is bad. It’s going to increase the number of payments you need to make.
In my mind, there are three reasons the snowball method helps people achieve their goals:
- You are only focusing on paying off one thing at a time. Instead of looking at your whole debt balance, you are focusing on one card, car payment, student loan, etc. This reduces stress by keeping it simple.
- You get a “win” sooner, because you are focusing on your smallest balance first. Instead of feeling relief in 3 years when all your debt is paid off (although you’ll feel it again then, too!), you get to feel a small sense of relief in 2 months, when you pay off your smallest balance.
- By breaking it down into bite-sized debts, you get a win every time you pay something off. You can feel a sense of accomplishment 4 times instead of once when all 4 cards are paid off.
But what about those of us who don’t need to pay down debt?
The Savings Snowball
I’m a list person. I love to make to-do lists and check things off. This snowball method would work fabulously for me if I had any debt to pay down.
But I don’t (thankfully)!
So how can I apply this psychologically-stimulating snowball method to savings?
“Pay down” my savings accounts, of course! Here’s my plan:
Right now, I have a few “imaginary” savings accounts. They are all within 1 bank account to keep it simple for me, but I have them broken out into categories in a spreadsheet so I can keep track of how much money overall I need in that savings account, and how much I can be spending every month, year, etc. in these categories.
Here are my misc. savings account for right now:
Medical – $200
Travel – $2,000
Car insurance lump payment – $404
Gifts – $400
Guests (we like to have extra money around to take family/friends to dinner or do fun local stuff with them) – $200
Next car/repairs for current car – $5,000
Taxes – $1,000
We are also saving for a house payment, and want at least $8,750 in an account for that.
And let’s not forget the most important…my husband’s IRA, to which we can contribute $5,500 this year. I still haven’t found a job 🙁 so no IRA for me yet. When I get a job, we will need to contribute to my IRA as well. But for this example, I’m just worrying about our current savings needs.
We should have at least an extra $2,000 to sock away every month.
So we can assign arbitrary minimum payments (I used 5%) and “pay off” each savings account to its full balance using a version of the snowball method.
Here’s how our year looks with the savings snowball:
|Taxable investment account*||$545||---|
In one year, we can meet our savings goals AND have money left over to go into our taxable investment account. Score!
Once again, I didn’t factor in any interest or returns that I will be earning in my accounts. The down payment and misc. savings should earn
1.05% (now 1.20% with this account) and the IRA will hopefully earn an average of 7% a year (using one of my favorite low-cost index funds).
Remember how I said that the debt interest is bad? That interest can increase your debt balances by 3-20%, meaning you’re more in the hole than when you first purchased the item or got the loan.
This savings interest, however, is a GREAT thing. This interest is making you more money, instead of putting you further into debt. And what’s better than making money without lifting a finger?
If you wish you had a way to encourage yourself to save more, I recommend using this savings snowball method. Give yourself those small, focused wins so you will continue on until you meet your goal. Your future self will be so happy that you did.