J.C.’s Money Blog

When I first heard of Dave Ramsey and his debt snowball concept, I was shocked and dismayed. How could a professional personal finance writer propose a system that costs you more money in interest than you need to pay?!

For those who don’t know about the debt snowball, it works as following:

1. Take all your different debt accounts and pay the minimum payment each month.
2. With any extra money you can spare, pay it to the account with the smallest balance.
3. After the smallest balance debt is repaid, you have the extra money you can spare each month plus the minimum payment on the smallest balance that you don’t have to pay anymore, this money is then paid against the new smallest balance account.
4. Repeat until all debt is paid.

The snowball effect seems to come into play, because as you pay off each account, you can apply more money each month to the new target. You kill off the weakest enemy and gain strength to fight the next bigger one each time.

What I found bad about this system is that it is not mathematically correct. In order to pay off the debts the fastest (and therefore paying the least amount in finance charges) is to do the following:

1. Take all your different debt accounts and pay the minimum payment each month.
2. With any extra money you can spare, pay it to the account with the highest interest rate.
3. After the highest interest rate debt is repaid, you have the extra money you can each month plus the minimum payment on the highest interest rate balance that you don’t have to pay anymore, this money is then paid to the new highest interest rate account.
4. Repeat until all debt is paid.

The second method is correct, because the interest rate is the cost of the debt. You should pay off the most costly debt first to save on finance charges, because finance charges are what put you deeper and deeper into the whole. All those inspiring charts you see about the power of compound interest applied to savings work exactly the same for debt, except to make you poorer every month.

Although the second method is correct, it is wrong. Mathematically it is the cheapest and fastest way to get out of debt, but for most people Dave Ramsey´s debt snowball will work better, because personal finance is much more about psycology than math. People can to get excited about debt repayment and watching their debt enemies drop one after the other, not by rejoycing that their system works best on paper.

The reason Dave Ramsey’s system will work better, is because people will find extra money each month to pay off debt when they feel the momentum of closing accounts and writing one less check each time. The snowball effect is the psycological momentum that builds with the small victories, not the extra cash from minimum payments that no longer have to be paid.

Hey, if we were machines that could always make the best financial decisions based on sound reason and math, we wouldn’t get into consumer debt in the first place.