One of my favorite concepts from Dave Ramsey’s Financial Peace University (FPU) is the debt snowball. The debt snowball is the second of Dave’s baby steps to financial peace and is a technique for paying off debt that pays off the smallest debt first, the next smallest debt next, and so forth.
The debt snowball starts with you listing all of your debts. You then pay the minimum on all your debts except for the smallest debt. With the smallest debt, you pour all of your excess cash to paying it off. An example: If you have a $40,000 student loan, a $2,500 credit card bill, and a $15,000 outstanding balance on a new car, the debt snowball technique has you pay the $2,500 bill first, the $15,000 bill second, and the $40,000 last. While you’re paying the $2,500 credit card bill, you continue making minimum payments on the two other debts. The end result is that you pay off the smallest debt quickly.
You may have noticed that I made no mention of considering interest rates when determining which debt to pay first. From a mathematical perspective, it certainly makes more sense to pay off debt with the highest interest first. Dave Ramsey teaches, though, that if personal finance was strictly a mathematical issue, hardly anyone would be in debt. On the other hand, Dave recognizes that personal finance has a large behavioral and psychological component to it. By paying off the smallest debt first, you receive a psychological victory that rewards your discipline. Having achieved this small victory, you’re then more likely to stick to your debt reduction plan. You then focus on the second debt and gaining another psychological victory.