This Popular Get-Out-of-Debt Strategy Could Cost You $1,411

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You may not want to use the debt snowball method if you're hoping to maximize your interest savings.

There are many different techniques that you could use to pay off money that you owe. But one of the most popular budgeting methods is called the debt snowball. The debt snowball was promoted by personal finance guru Dave Ramsey as a means of repaying debt more easily by taking human psychology into account.

See, with the debt snowball method, you make minimum payments to all creditors but make extra payments to the debt that has the lowest balance first. That way, you should hopefully get that debt paid off quickly, which will help you stay motivated to continue reducing your credit balances.

There's just one obvious problem with this: The debt that you have the lowest balance on may have a lower interest rate than other loans that charge much higher rates. If that's the case, you'll be focused on paying off inexpensive debt first while holding on to your high interest debt for longer -- and continuing to pay more interest over time.

While the idea of scoring quick wins to keep on track definitely has merit, you need to be aware of how much the debt snowball method could end up costing you.

The debt snowball strategy comes at a steep price

The exact amount of extra interest that you end up paying due to using the debt snowball strategy is going to vary depending on your personal situation. The key determining factors are the bigger the difference in interest rates on your debt and the longer it takes to start tackling your high-rate loans.

But to give you an idea of how much this strategy could cost you, let's take a look at an example. Say you owe:

  • $1,000 on a personal loan at 5% interest and $150 minimum payments
  • $1,500 on a credit card with 17% interest and $40 minimum payments
  • $2,500 on a car loan with 4% interest and $200 monthly payments
  • $5,000 on a business loan with 7% interest and $175 monthly payments
  • $6,000 on a store credit card with 27% interest and $195 monthly payments

If you follow the snowball approach, you'd pay back the debt in the order they are listed here, starting with paying off your personal loan and then finishing with paying off your store credit card. This approach to repaying debt would take you 26 months and would cost you a total of $19,266 to repay your entire loan balance.

But, what if you paid back your debts with the highest interest rate first instead. This could mean starting with the store card, then the card with 17% interest, followed by the business loan, and so on, all the way down to the personal loan at 5%. This method is called the debt avalanche method. With that approach, you'd be debt-free in 24 months and you would end up spending only $17,855 in total to repay what you owe.

The snowball method in this case would have cost you an extra $1,411 and would have forced you to pay back your loans for an extra two months.

Now, Ramsey encourages you to make extra payments using the snowball method, and paying extra each month would accelerate the payment timeline under either approach. But even though extra payments would reduce total debt payoff time and provide more interest savings over time, they wouldn't change the bottom line. Your total payment costs would be considerably higher if you paid off your debts from lowest to highest balance rather than highest to lowest interest rate.

Should you use the snowball method?

Your calculations may look different than these, but in almost all cases, the snowball method will end up costing you more over time.

Now, you may decide you need to use the snowball method anyway, because it's the best budgeting method for your personality. For example, if you don't get the psychological benefits of seeing some of your debts disappear quickly, you will have a hard time staying on track with debt payoff. But there are other ways to stay motivated, including using visual tools such as a thermometer you color in as you get closer to your debt payoff goal.

You may also have the option of consolidating your debt, which means taking out one new loan at a lower rate to pay back all of your different creditors. If this is doable, you would simplify repayment significantly and wouldn't have to make a choice about which debt to pay first. Plus, hopefully you'd save money in the process.

Ultimately, if you're taking any approach to try to pay off your debt, you're making a smart financial move. But just be aware that the snowball method can cost you, so make sure you consider the downsides.

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