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.

Good Debt

In my daily blog reading I came across an interesting discussion on the government debt. There's only so much you can write in a comment, so I figured I'd blog about it myself.

Most personal finance bloggers will proclaim the benefits of being debt free, living below your means, and saving for various reasons. I agree with the sentiment, but I think we need to be careful that we don't over generalize the point here. For example, we save to meet goals, not because we like to stare at money. If you don't set your goals, saving money isn't bad, but it's not really serving its true purpose. Believe it or not, debt can serve a purpose too.

When I was reading in Economics about the government spending and government debt, I found what was not said much more interesting than what was said. There was no talk over whether debt was good or bad, or if the government would be better off in a surplus or not. Reading the textbook, I realized people would be better off running their own finances much more like the government. I know that's probably contrary to everything you've ever heard.

Debt has really developed a bad name over the years. I've had panic attacks in the past, worrying about how I was going to manage to pay my Visa bill or mortgage, so I understand why some people feel that way. Not only that, but while many of us received no real financial advice from our parents, I'm sure most of us heard again and again that debt was horrible. However, I believe this is an over-generalization. Debt can be horrible, but just because it can be, doesn't mean it always is. After all, I'm sure most of you heard the contradiction from your parents that the mortgage was a "necessary evil." I know I did.

The problem is that the word "debt" is being used too broadly. I would agree that consumer debt, which is a form of debt, IS a terrible idea. Consumer debt is debt used to fund the consumption of goods and services for personal or family use. This is what most of us are referring to when we say that all debt is bad. Examples: Any over due credit card balance, car loans, buy-now-pay later loans (appliances, flooring, etc), lines of credit for household items, etc.

On the flip side though, debt can also be a great tool to allow you to invest in opportunities you wouldn't be able to do by your own means. For example, educating yourself with student loans in order to provide your family with a greater income than you're currently receiving. Buying a real estate investment property that translates into higher cash flow. A working capital loan that allows you to start or grow your own business. Of course there are risks involved, but what in life doesn't have risks. There is no guarantee you'll have your job next month, or your so called safe investments will pay off either.

Governments work the same way. They borrow (or should) to expand our future income potential and to improve our economic state. Whereas consumption spending such as health care, schooling, etc. needs to come from our revenue sources. Borrowing for these items (as badly needed as they are) is just a bad idea. Funds for these items can only come by reducing our expenditure in these areas or moving funds from other areas of consumption. Just like we do with our own personal budgets.

Borrowing for the Olympics makes sense because it brings in more tax revenue, future tourism, and greater immigration. Borrowing to house the poor doesn't have that same return unless this leads to increased employment and lowered use of government services.

Have you been lumping all debt together? What are your thoughts on this "great evil"?

Plastic Debt

Like just about anything else, credit cards can become a problem if they are abused. And just like I would recommend avoiding alcohol or gambling if you have a problem controlling it, I'd recommend avoiding credit cards for the same reason. But, just like most other vices they aren't evil in and of themselves.

The Wealthy Barber suggests avoiding credit card use altogether. Which is probably the safer route to take for the general masses. If you aren't doing well at tracking how much you're spending then this might be the way to go. After all if you are spending cash you can watch your account balance to see how much money you have left at any given point.

I heard some great advice a few months ago. A credit card should be considered a method of payment and not a method of finance. So whether you pay by cash, debit card, or credit card you shouldn't spend more than you can afford to. If you do that than it really doesn't matter how you pay and it just becomes a method of payment.

I'll talk about borrowing money sometime in the future, but I think you already know that 19% is a bad deal. So if you do need to finance something, look elsewhere. Heck, I'll even give you a better rate than that. ;)

For any of this to work, you don't want to carry a balance on your credit card. So when the bill comes in pay it in full. Which should be no problem if you stick to the budget you created.

So if you can afford to pay cash, why would anyone use a credit card?

Well besides the convenience, and the ability to shop online, you can also earn rewards probably faster than any other rewards program. Everything from free gas to mortgage payments to trips around the world.

These rewards can add up quite quickly if you use your card a lot. In fact I put everything I can on to my card. I just recently switched over most of my bills to the credit card just to increase my points. If I get a student loan or a bursary, I still put the tuition on my Visa and then use the loan amount or bursary to pay the Visa. I'd throw my mortgage on there if they'd let me, but they don't seem to like that for some reason. ;)

I used to avoid annual fee cards like the plague too, but now I welcome them. I pay $20/year on my card which doubles the points I collect. For each $100 I spend I get $1 in bonus dollars. Without the $20 fee I'd have to spend twice as much for the same benefit. That extra $20 will get me about $250 in bonus dollars this year, so well worth it.

Now there are lots of bonus cards to chose from and I thought about writing a posting on that as well, but I have decided against it. I'm using the Desjardins Visa myself and I use the bonus dollars to go into an RRSP. It has a better return on the points for this than any of the others I looked at. I contemplated an Air Miles or Aeroplan Card, but I didn't like the restrictions (limited airlines, dates/times, etc). The flight cards might work out better money wise, but I'm happy with what I'm getting. I might change my mind in the future, but regardless my spending is working for me.

After all, it's free money for just spending what I normally would anyhow!