Snowballing is a common debt management technique intended to accelerate reduction of the overall debt burden for people with several different loans. A person or a family dedicates a fixed amount every month to go towards debt repayment. Out of that amount, the minimum required payments are made on all the loans first, and whatever is left goes towards reducing the smallest debt. Once the smallest debt is completely paid, the amount available to pay off other debts becomes larger, because we are keeping the total amount fixed and one debt is now out of the picture. At this stage, the next smallest debt becomes a priority, and once it is paid, the amount available for the remaining debt becomes larger. This way, we eliminate debt after debt, beginning with the smallest and going up. Because fewer and fewer debts remain and the amount we dedicate for debt repayment is fixed, the repayment process accelerates.

While this technique is quite common and popular, its effect is mostly psychological. Naturally, the number of debts will go down faster if we deal with the smaller ones first. And when we get fewer bills every month, we feel much better. All of a sudden, there is a light at the end of the tunnel and we start to believe in our ability to get out of debt once and for all. Our mental state is very important in the way we manage our finances, and in this sense snowballing is a good debt management technique. But it doesn’t make much financial sense.

What makes more sense is paying off high interest debts firs and low interest last. Snowballing may reduce the number of debts faster, but not the overall amount of debt. The later can be achieved by paying high interest debts first. For example, imagine that you have a $500 loan at 4% (for example HELOC) and a $1,000 loan at 20% (for example a credit card) and want to dedicate $500 to debt repayment this month. If you snowball, you will pay the smaller debt first. Next month, your remaining balance will be $1,017. But if you use your $500 to pay a half of the high interest debt, your balance next month will be only $1,010.

Seven dollars doesn’t seem like a big number, but this difference will increase every month due to the compounding effect. Of course, this example ignores the minimum required payments and possible early repayment penalties. Also, you should be looking at the net real interest rates as opposed to nominal, because interest on some loans may be tax deductible and compounding can be annual, quarterly, monthly or even daily. You will probably need a professional financial planner to figure out what is best in your specific situation. But the basic principle of paying high interest debt first can make you debt free years earlier and save you thousands and thousands of dollars in interest expense.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.