Given it’s a new year and many folks having “paying off debt” at the top of their list of New Year’s resolutions, I thought I’d dust off and update one of my older articles about the Snowball Method. If you’re like the majority of Canadians, you have multiple types of debt on your books. Maybe you have a mortgage, a car loan, a line of credit and a credit card. With Canadians currently owing almost $1.59 for every dollar they earn according to data from Stats Canada, it’s no wonder one in three Canadians reported feeling overwhelmed by their debt.

So where do you start if you want to try and get out from underneath all that crushing debt?

The Snowball Method – Step 1

In the snowball method of paying off debt, you start by ordering all of your debt from highest interest rate to lowest interest rate. If you have the above four types of debt, your situation might look like this:

• Credit card: $1,500 balance – 19.99% AIR
• Line of Credit: $10,000 balance – 9.99% AIR
• Car loan: $16,000 balance – 4.99% AIR
• Mortgage: $500,000 balance – 3.99% AIR

Step 2

Next, you need to work out the minimum monthly payment on each of your accounts. Maybe it looks like this:

• Credit Card: $70
• Line of Credit: $280
• Car loan: $370
• Mortgage: $2,600

The total of all minimum payments here is $3,320 per month. Crazy, isn’t it? Yet that is all too common these days.

Step 3

From there, you need to determine how much you can afford to pay towards your debt each month. It needs to be more than the sum of the minimum payments across all accounts – more than $3,320, in this case.

Let’s say for the sake of this example that you can afford to pay an extra $500 above and beyond the minimums, for a total debt repayment of $3,820 per month.

Step 4

From here, it’s a matter of paying down your debt. There two very important things to keep in mind:

• First, you should make sure that they money you’ve set aside for debt each month actually goes toward paying down that debt. The day you get your paycheque, the first thing you should do is make all planned payments against your debt. That way you aren’t tempted to spend that money on other things!
• Second – and this is key – that extra money you set aside for debt ($500 a month in this example) should be put toward paying off the debt with the highest interest rate. In this case, that’s the credit card debt.

That is the main mechanism behind the snowball method. You keep applying the extra money toward the debt with the highest interest rate, then when that debt is paid off, and here’s the cool part, you take all of the money you were paying to that debt ($570 a month, in the case of the credit card example), and pay it toward the debt with the next highest interest rate – the line of credit, in this case. This way, you’ll be paying $850 a month to your line of credit!

When that’s paid off, you take that $850 and apply it to the next-highest interest rate debt, the car loan in this case. Notice how the amount of money you pay to each type of debt snowballs for each one you get paid off? That’s how the method got its name!

Bonus – Step 5

Once you’ve got everything paid off except your mortgage, consider using all that extra money (or at least most of it – you’ve gotta live a little!) to invest into a rainy day fund or retirement fund. Your future self will thank you for it!

Wrapping it Up

Ever wonder why you pay the thing with the highest interest rate and not the thing with the most money outstanding? Think of it this way. If you invested $1,000 at 10% interest, you’d make $100. If you have $1,000 in debt at 20% interest, you’re paying $200. In other words, the creditor who’s lending you money at the highest interest rate is making a killing off you – and you need to put an end to that!

The snowball method works with any amount, as long as you can afford to pay a little more than the tot minimum across all your accounts. Follow it carefully, and you’ll give yourself the best chance possible of getting out of debt!