(Case Study) Mr. Rajat Kumar, 40, a professor in a private university had a stable job and income. But managing too many debts was giving him a headache. Besides having an outstanding balance on 2 of his credit cards he had also taken a car loan and a personal loan. However hard he tried to pay them off the bills kept on piling and the debt never seemed to shrink. He wanted to pull himself out of this debt trap but did not know how to go about it.
A simple research on the internet introduced him to the idea of the snowball method to pay off the debts. It is a method of attacking the debts starting from the smallest balance to the largest, irrespective of the interest rates. At first all the funds are directed towards paying off the smallest debt, while paying the minimum balance of all other debt obligations. Once the smallest debt is paid off, the freed up funds are then used to pay the next smallest debt and so on. As the small debts get knocked off the list it enables a person to work towards the bigger debts in an exponential fashion. This approach is similar to a small snowball rolling down the hill that adds on a layer of snow with each turn and grows larger and gains momentum as it rolls down. A systematic repayment method does help the borrower to avoid getting into loan defaulters list and impairing the credit score which could lead to one looking out for personal loan for low CIBIL score.
Mr. Rajat decided to use this concept to jump start his journey of becoming debt free. He made a list of all his debts starting with the one with the least balance. He had
Debt 1: Rs 30,000 balance (Rs 500/month minimum)
Debt 2: Rs 42,000 balance (Rs600/month minimum)
Debt 3: Rs 50,000 balance (EMI of 1720/month)
Debt 4: Rs2,20,000 balance (EMI of 3250/month)
Rajat prepared a monthly budget listing down all his income sources, expenses and the minimum amount that was needed to pay each month on each of the debt. The extra cash left was the money that he could use for debt elimination. He calculated that the maximum payment that his finances reasonably allowed to pay off the first debt after covering for the minimum monthly payment of all other debts was Rs 6000/-
Every month this extra money was used to pay off the first debt. He made a monthly payment of Rs 6500/- (Rs 6,000 + 500 ) and in about 5 months he was able to pay off his Debt 1 completely. The entire amount that was used to pay Debt 1 (monthly minimum+ extra money) was then used to strike the 2nd target on the list. With a monthly payment of Rs 7,100 (6,500 + 600) he was able to pay off Debt 2 in 6 months. This way by diverting all the freed up money towards the next debt he created a snowball and kept knocking them off one by one. As the snowball increased in size so did his momentum and motivation to become debt free. After the first 3 debts were paid off he had an extra Rs 8100/- , so he made a monthly payment of Rs 13,100/- to pay off the last debt.
The snowball method strikes the smaller debts first even if one is paying a high rate of interest on the larger debts. In the end, one may end up paying more than if one had dealt with the high interest debts first. But the reasoning why snowball method works in most cases is that when a person sees progress and results he tends to stick to the plan and succeeds in becoming debt free. It builds momentum and gives a sense of achievement along the way. When Rajat knocked off the debts from his list it gave him a psychological feeling that his efforts were bringing rewards. That sense of victory motivated him to continue his journey of reducing his debts. On the other hand if he handled larger debts first just because they have a high rate of interest, they would take time to go off. If he did not see positive results for quite some time he would tend to lose momentum and leave the efforts in between.
By prioritizing the easy debts first, the snowball method made Rajat’s debt more manageable and less intimidating every step of the way. The small victories with small debts kept him steady on his goal. In fact it proved to be quickest method that helped him pay off his debts and re-establish a strong financial footing.