When it comes to constructing a successful plan for paying off your debts, Dave Ramsey charts an entirely different course than most financial pundits and counselors.
Ramsey calls his method the "Debt Snowball." It is an integral part of his "Baby Steps" routine for complete financial fitness. "This is the toughest of all the Baby Steps," he writes. "It is so hard, but it is so worth it."
Rather than attack debts in order of interest rate — say, from highest rate to lowest — Ramsey suggests that his clients pay off their debts in order of outstanding balance: from smallest to largest.
(Note that this excludes your home mortgage, as well as any similar real-estate or business loans which total more than 50 percent of your annual income.
If more than one loan or debt have similar balances, list the highest-rate debt first.
At that point, then, you round up your money and start with the first debt on your list. Pay the minimums on all debts except the first, and keep them current. Throw every cent of money you can at your smallest-balance debt. When that is gone, you then "snowball" (add) that debt's payment into your monthly payment for the next debt on your list.
Building a Debt Snowball
"The Debt Snowball is designed the way it is," Ramsey writes in Total Money Makeover, "because we are more concerned with modifying behavior than correct mathematics. Sometimes motivation is more important than math. This is one of those times."
The bright idea here is to get some "quick wins." The payoff is twofold. For one thing, human nature is such that we tend to bog down on tasks, or quit them altogther, if we cannot see ourselves making progress toward the goal. That isn't a problem here: You write down all your debts, and you see yourself making quick progress — swatting away your smallest debts like the nuisances they are. Many people magnet their Debt Snowball charts to their refrigerators so they can continually see how far they've come.
"I don't care if you have a master's degree in psychology," Ramsey says. "You need quick wins to get fired up. And getting fired up is super-important."
Additionally, the quicker you pay off a debt — any debt — the quicker you can snowball (add) its payment to the next debt on your list. Your debt payments therefore "compound" upon themselves as you slice through your debts, one by one.
"All the money from old debts and all the money you can find anywhere goes on the smallest debt until it is gone," advises Ramsey. "Every time the Snowball rolls over, it picks up more snow and gets larger, until by the time you get to the bottom, you have an avalanche."
And in this case, an avalanche is exactly what you want to see coming your way.
The Debt Snowball Rolling
We can clarify things by illustrating how Ramsey's plan might unfold for a fictional household. Just for kicks and giggles, we'll call this household the Ormans.
At the beginning of the year 2005, the Ormans figure out that their financial standing is on shaky ground, and they're ready to do something about it. Their debts look like this:
Notice that those debts, as listed, are not in any particular order. Ramsey's "Debt Snowball" tells us that to get started, we must write down all the debts, in ascending order, from smallest- to largest-outstanding balance. In this case, the Ormans' debt lineup would roll out looking like so:
Now the Ormans have a starting point and a battle plan. They're ready and dedicated to the task at hand: Time to pay off the debt.
NOTE: In a true "Debt Snowball," the Ormans would take whatever extra cash they can squeeze from their budget, or any extra income, or any income from selling "stuff," and put it toward paydown of the first (lowest-balance) debt on their list. For the sake of simplicity, the following example does not account for any such exta payments. Also, balance calculations are estimations only.
Obviously, in the real world, extra payments can make a huge difference.
Skip ahead two months. The Ormans have made payments as shown above, and have eliminated Medical Debt #1. They remove that debt from their "Debt Snowball" list. Now, as per Ramsey's suggestion, they add the payment from Medical Debt #1 ($40) into the payment for the next debt on their list. This happens to be Family Loan, whose payment started at a mere $5. With the snowballed payment from Medical #1, Family Loan's payment now becomes $45:
Give the plan another three months, and the Ormans have eliminated their second debt (Family Loan). They erase it from their list and roll its payment into the next debt (Medical #2), as shown below.
Two months later, Medical #2 is gone. That payment ($65) is now applied to the next debt on the list. The Ormans now begin sending payments of $113 to Card #2:
Two more months fly by; it's now October 1, 2005. Thanks to the Debt Snowball, the Ormans' debt on Card #2 has evaporated, and they have eliminated four of their eight debts. The payment for Card #1 now becomes $156 per month:
By now, you probably grasp how this works. Six months later, the Ormans dispatch their highest-rate debt. At that point, their snowball plan looks like this:
And that's it. Using Dave Ramsey's "Debt Snowball" plan, the Ormans are now debt-free except for their mortgage. It might not have been the most mathematically-intelligent mode of debt reduction, but it worked.
And isn't that what's most important?