The average consumer debt in Canada for Q2 2022 – excluding mortgages – totalled a whopping $21,128, with mortgage borrowing also on the rise year on year. This is little surprise with rising interest rates and a climbing cost of living, causing many Canadians to look at borrowing via credit cards and loans to support an increasingly expensive lifestyle. When it comes to paying off this debt, it can be difficult to know where to start. Yet making a small start and chipping away at your debt bit by bit can result in a huge impact overall. This is the main premise of the debt snowball method. If you like seeing immediate results in your efforts, the debt snowball method could be a good choice for you, as it works by the logic of paying your debt off from your smallest loan to your biggest. In this article, we will explain how the debt snowball method works, and how it could work for you.
What is the debt snowball method?
Contrary to the debt avalanche method, the debt snowball method is a way of gaining instant gratification while repaying debts. Although not the cheapest method of debt repayment, it can work as a great motivator for working through repayments. The debt snowball method works by making minimum payments to all of your debts. You then put as much of your additional funds as possible towards your debt, beginning with the smallest balance first. Once you have paid off the smallest debt, you then use your additional funds towards the next smallest balance you owe. You then work on getting this debt paid off too, repeating the process until you get to the highest balance owed. The debt snowball method is effective because you see results quickly and relatively easily. It has a psychological effect, and many people think it helps you to pay off more of your total debt than any other debt repayment strategy. The only downside is that it is not the cheapest form of debt repayment. It may cost you more in interest over a longer period of time, depending on your debts and their interest rates.
How do you start with the debt snowball method?
If you want to get started with the debt snowball method, the first thing to do is begin making a list of all of your debts. You should then order them from the smallest to the largest. It could look something like the following:
- Overdue hydro bill – $125
- Credit card balance – $250
- Unsecured line of credit – $300
- Loan from a friend for car repairs – $900
- Student loan $5,000
- Car loan – $10,000
- Mortgage – $20,000
With this list, you would then ensure to make the minimum payments on all debts, except the smallest. For the smallest (the hydro bill), you would pay as much as you possibly can. Once the smallest debt is paid off, you then repeat in this order until each debt is paid in full.
What is the interest rate on debt?
Typically, there are two different types of interest on debts – daily simple interest, and compounding interest. Credit card debt is notoriously expensive compared to other debts like car loans or personal loans. Understanding the interest rates on your debt may help you to decide on a repayment strategy.
Daily simple interest
Daily simple interest is interest that is calculated most often for short term personal loans, including car loans. If you purchase a vehicle for $5,000 at a rate of 4%, this percentage is known as your annual rate. It is divided by days of the year into a daily charge which is factored into your monthly payments. Your payments will include the interest, as well as the principal of the debt. As the principal of your debt decreases over time as more payments are made, so too will the overall cost of your interest payments as it is calculated on the remaining balance. On personal loans, usually the term of the loan and the payment amount are fixed, which means there is no change in your payment as time goes on. If you make all of your payments in full and on time, you will complete your repayments as expected by the end of the term. It is a straightforward way to make a purchase.
Compound interest is a little more complex. Although it is great for growing your savings, it can become pretty expensive when it comes to making repayments. Loans are usually investments made by lenders, who understandably want a return. As credit card debt is essentially an unsecured loan, it means there are no assets to secure the loan against, making it riskier for the lender. For this reason, the interest rate will typically be higher than with a secured loan and it compounds. Most credit cards have a standard interest rate of around 19% a year, which is broken down into a daily rate. Say you owe $10,000 on your credit card, and the daily interest rate on your credit card is 0.052%. Once the interest is added, your balance will be around $10,005.20. If you go shopping and spend a further $2,000, your new balance will be $12,005.20. You will be charged the daily rate of 0.052% on the $12,005.20, which brings your balance up to $12,011.44. This is because you get charged interest on top of your former balance including interest. If you only make the minimum payments on your credit card, it would take a long time to repay it and could cost you thousands in interest alone.
Why does the debt snowball method work?
The debt snowball method has the great advantage of allowing its enablers to feel as if they are achieving something. It is great for motivation as it allows you to track your progress as you work through repaying your smaller debts off. According to research carried out by the Journal of Consumer Research, the debt snowball method is the most effective as these small wins are more motivating than say the debt avalanche method, which is the strategy of paying off the most expensive debts first. Often, the smallest debt is all many Canadians can afford. By chipping away at these smaller debts, it is possible to become debt free by being consistent and putting aside any spare funds to go towards your debt repayments. The debt snowball method may not work so effectively for those who want to save money wherever possible. In this instance, the debt avalanche method may be more effective by clearing the most expensive debts with the highest interest rates first. This strategy enables you to save more money, but it may not be as motivating in terms of seeing instant results.
If you want to learn more about the debt snowball method or repaying your debts, book a free consultation with Spergel. Our experienced Licensed Insolvency Trustees have over thirty years’ experience of helping Canadians pay off their debts and gain debt relief. The sooner you reach out, the sooner we can help – you owe it to yourself.