Credit card debt bothers many of us. If corrective steps are not taken, debt level starts ballooning, drawing one towards a debt trap.
With multiple credit cards to repay, the usual approach is to line it up by its interest rate (high to low) and start repaying them in that order. It’s mathematically the correct way - as it saves the most money.
However, what if one happens to run a high debt on a card that also has the highest interest rate? In that case, it will be frustrating to notice multiple credit card loan accounts remaining active – even after years of debt repayment.
A 2016 Harvard research paper alternatively suggested the ‘pay the smallest debt first’ strategy. Their research found that people are more motivated to get out of card debt not only by concentrating on one account but also by beginning with the smallest.
However, getting out of debt is more of a mind game. One should therefore consider this method – known as the ‘snowball method’, which essentially asks borrowers to prioritise smaller debt first, if there are multiple debt accounts having similar interest rates.
Snowballing - How does it work?
Consider three credit cards – card 1, card 2 and card 3. List them by their outstanding balance, interest rate and minimum amount due.
In the usual method of repaying, first of all, you would pay minimum amount due on all your card loan accounts (totalling Rs 37,000) to avoid penalty charges.
A minimum amount due of 5% of loan outstanding has been assumed in this example. Any money beyond Rs 37,000 is used towards repaying credit card account that has the highest interest rate of 16% pa (CC1), then 15% (CC2) and finally 14% (CC3). However, since the outstanding balance for CC1 is also the highest at Rs 5,00,000, it will take longer to repay it, demotivating you in the process.
In the snowball method, one continues to pay the minimum amount due on all loans. However, any extra money is funnelled towards repaying the smallest loan and dedicating as much money as possible until it is repaid. And later the second smallest loan and so on. The idea is that by doing this you will gain momentum by watching debts disappear - like a snowball growing bigger and bigger.
In the snowball method, one continues to pay the minimum amount due on all loans. However, any extra money is funnelled towards repaying the smallest loan and dedicating as much money as possible until it is repaid. And later the second smallest loan and so on.
The idea is that by doing this you will gain momentum by watching debts disappear - like a snowball growing bigger and bigger.
In this example, you start repaying CC2 first, with the lowest balance of Rs 40,000. Once it is fully repaid, you divert its minimum amount (of Rs 2,000 which is no longer required since you have repaid it fully) to repay the second smallest debt– CC3.
In effect, you pay at least Rs 12,000 towards CC3 - Rs 10,000 (its minimum amount) plus Rs 2,000 (diverted from CC2). Any further savings is targeted towards repaying CC3. Once CC3 is fully repaid, you redirect a larger chunk of Rs 12,000 (equivalent to minimum amount of CC2 and CC3) towards CC1 as well as any other savings.
This way, you could ‘snowball’ your payments together to repay debts quicker. By closing one credit card account after another, you get a sense of progress which motivates you to move closer towards your goals. It is small victories like these that propel you to finally come out of debt situations.