What kind of snowball do you want?

Chances are good that you've heard of the “Snowball Method” of debt reduction. It works like this. Say you have several debts to pay off. You add up the minimum payments on those cards, add in an extra “acceleration” amount to one or more of the cards, and pay down the debts. When one card is paid off, you take the payment that you were making on that card and throw it at the next card(s) (the “snowball” part). This accelerates the paydown of that card. Repeat this process until all the debts are paid off!

But there's an open question: What debts do you pay off first?

The answer: It depends. What's more important to you — saving as much interest as you can, or seeing results fast? If you want to save as much interest as you can, you pay off the debt with the highest interest rate first, because your money works the hardest there. If you want instead to pay off a card as fast as possible, you pay down the card with the lowest balance first.

Here's an example. Suppose you have three debts, with the following balances and interest rates:

$3,000 at 7% — initial minimum payment of $60
$5,000 at 14% — initial minimum payment of $100
$7,000 at 21% — initial minimum payment of $140

Three assumptions:

1. The payment on each card will be at least the initial minimum payment. The minimum payments will go down as you pay down the balance, but we'll always pay at least $60 to the first debt, for example.
2. The last payment, if different from the minimum payment above, won't be applied to the next card until the following month. (We'll assume that you use the extra to celebrate — you deserve it!)
3. Any tax advantages have already been figured into the rates.

Now I'll outline three repayment scenarios — a) no acceleration (you don't “snowball” the payments); b) accelerate the debt with the lowest balance with an additional $50 per month, and continue snowballing for the higher-balance debts; c) accelerate the debt with the highest interest rate with an additional $50 per month, and continue snowballing for the lower-rate debts. Here's how they compare:

• No acceleration. In this case, only the initial minimums are paid toward the debt, and once a card is paid off, there's nothing extra applied to the other debts. The first debt (the lowest balance) gets paid off in 60 months, the highest balance gets paid off in 120 months, and a total of $12,885.97 in interest is paid.
• Lowest balance first. Early results are key here. An extra $50 toward the lowest balance cuts the payoff time almost in half — down to 34 months! The snowballing pays off the other debts in another 34 months, for a total of 68 months and $8,698.12 in interest paid — over $4,000 less that without acceleration!
• Highest interest rate first. This results in the most interest savings, but it takes longer to knock out one of the debts. The extra $50, applied to the highest-rate debt, pays that one off in 60 months. (In this example, the lowest-balance is paid off at the same time without acceleration — just a coincidence!) Snowballing the other payments into the last debt kills that one in only 4 more months. The total interest paid is $7,330.59 — the lowest of the three cases.

So, from this relatively simple example, a couple of things are clear. First, accelerating and snowballing your debt repayment saves interest over not doing it all. Second, attacking the highest rate debt first results in the most savings, but at the expense of “delayed gratification” in seeing the debts go away completely.