Monday, April 26, 2010

Debt Snowball

OK, my wife got offered a casual postiion as a nurse. So it's finally time to speed up the debt repayment. Don't worry, we plan to enjoy a little of the extra funds too ;). So how do I plan to dig out of this hole? I'm going to use a little technique called a debt snowball. A debt snowball is actually better than it sounds. Don't blame me, I didn't come up with the name.

I've heard it discussed several times with different names. The first time I heard it was several years ago in a free budgeting program offered at our church. It was more recently discussed by Primerica when I chatted with them and since then I've read it in several books.

So, what is it? It's a debt reduction strategy used to pay down multiple accounts. If you only have one debt to pay down then, this isn't going to help, but good for you! However, if you have multiple credit cards or student loans, or lines of credit with amounts owing, this could be a good strategy to help you out.

I'm sure you've heard people say that paying the minimum on a credit card balance is just stupid. The reason for that, is because you're paying almost all interest and have no hope of paying the card down. So, you might currently be paying more than the minimum on multiple loans. This can get quite discouraging as the debts never seem to go away.

With this strategy though you will be paying the minimum on all of your debts except for the smallest one. Anything extra that you were putting towards the other loans, or any other money you were planning to use to pay down the loans, should now be put towards this smallest loan only. You can see how this loan would get paid off fairly quickly.

Once this loan is paid off the payments are then applied towards the next smallest loan. Only this time the debt repayment has grown because it includes the minimum payment from the first loan and the minimum payment from the second loan. Like a snowball rolling down hill (hence the name). By the time you get to the larger debt you're applying a much larger payment.

Not only does this help to pay off the loans more quickly, it also give you a much greater sense of achievement as each loan disappears. I think the emotional response is the most important aspect of this concept. After all if you lose motivation, even your best intentions will fall by the side. So while you're technically better off paying the highest interest rate loans first, it is no where near as satisfying. However, if two debts are similar in size, you probably want to pay the one off with the higher interest rate first.

This only works if you can afford to pay more than the minimums though. If you can't afford to make all your minimum payments, then you need to fix that problem first. Hopefully you can do that on your own by adjusting your budget and sticking to it, or getting help by a professional if need be. I reached this point a few years ago and consolidated the loans into a home equity line of credit. This eased the burden, but now left me with a big loan to pay off. I'm saving this one for last.

Debt Snowball Example:

Let's say you have the following debts and for simplicity we'll ignore the increase with interest:

Visa - $225 balance - $25/month minimum
MasterCard - $1000 balance - $30/month minimum
Car Payment - $3000 balance - $175/month minimum
Line of credit - $5000 balance - $250/month minimum

Assuming you have an extra $200 to use above the minimums, you put that towards the Visa and it's paid off in one month. Yes, I made that simple on purpose ;)

Then the next month you apply the extra $225 towards the master card (note it's now $25 more already). Four months later the MasterCard is paid in full. Fast forward 14 months and everything is paid in full.

I'm going to put up my net worth as soon as my wife starts full time. Then if you're interested you can see a real life example of the debt snowball. Although, my balances are much higher than in the example given.

Anyone else tried this or willing to give it a try? Love to hear your experiences.

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