Aug 04, 2020

Debt Repayment: The Snowball Strategy

For better or worse, debt is an inescapable reality for most of us. Certain debts, like high-interest credit card debt or consumer debt, are often considered a drain on your budget. Other debts can be used to acquire valuable assets we otherwise could not, such as a house or car, or create leverage and magnify returns. Whatever your position on debt is, a near-universal aspiration is to ultimately become debt-free.

So how do we do that? Paying off debt in many respects is a lot like losing weight: It can be uncomfortable, it requires consistent and deliberate sacrifice and the payoff is often so far in the future it can be hard to believe you’ll ever get there. The debt snowball, made most famous by personal finance author and media host Dave Ramsey, is a debt repayment technique designed to strengthen our resolve when it comes to making debt payments. The strategy goes like this:

      • Make a list of all your current debts and order them from smallest to largest, regardless of interest rates.
      • Focus on tackling the smallest balance. You would make the minimum payment on all other balances aside from this one.
      • Be as aggressive as possible on making payments over and above the minimum payment on this particular balance.
      • Once you have paid this balance in full, roll the payments you were making toward it to the next smallest balance.
      • Repeat as necessary.

The Snowball Strategy and Human Nature

To be clear, this technique does not add any real financial advantage to your debt repayment – because you’re not prioritizing the debt with the highest interest rates first, you could end up paying more in total interest than you have to. That said, what makes this approach effective is how it reflects human nature. Whatever our debt’s starting point might be, we like to see clear, unmistakable signs of progress – and reducing the number of debts we have is progress. Making a $2,000 dollar payment and closing out a debt simply feels better than making a $10,000 dollar payment and reducing a debt from $100,000 to $90,000. Sure, the second scenario reduces your total debt by a larger margin – but if you are a human being, the first scenario will feel better. You experience a greater sense of accomplishment having zeroed out a smaller debt than you will simply “making progress” on a larger debt.

This sensation is part of a broader theory called Prospect Theory, which was developed by psychologists Daniel Kahneman and Amos Tversky. They discovered that people view gains and losses in terms of distance from a certain reference point or anchor. With debt repayment, the size of the debt (which will vary over time) tends not to be our reference point. Our reference point tends to be $0.00. Thus, our marginal utility gained from each additional dollar paid toward a debt is increasing as we approach a zero balance. The last payment made will inevitably be the “best” payment because we will have hit our target.

Dave Ramsey seeks to leverage (pun intended) this feeling. Beginning with the smallest debt is most motivating simply because it has a starting point closest to our anchor. Each payment becomes more rewarding. It motivates us to be as aggressive as possible because of the associated feeling.

Building a Habit

In his book Atomic Habits, James Clear posits the easiest way to form a habit it to make it attractive. Ramsey, using the underlying behavioral psychology found in prospect theory, seeks to make something as mundane and depressing as debt repayment into a rewarding experience. Once making aggressive payments becomes rewarding, it will become a habit. You will likely crave the sensation of making larger and larger payments. Readily available online balances complete the feedback loop by giving an up-to-date benchmark.

All that said, this technique is simple one, and some debt can be far too prohibitive for such a simple approach. Debts with extremely cumbersome interest rates, for example, might warrant a more granular approach. However, the underlying behavioral psychology has been tested and tried. Most debt stays on our balance sheet, eating away at our investable money for far too long, because we are biased toward the status quo. Making the minimum payment on all our debts is the routine we fall in to.

For some people, the snowball strategy can be the motivation needed to get out from underneath debt and on toward a debt-free life, while for others it is merely a starting point. Whatever your current debt situation might be, seeking advice from your advisor is always an appropriate choice – and all of us at Baird Retirement Management are here to help.

   

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