How to Do a Debt Snowball

This is part four in my series, Baby Steps to Financial Freedom.

So how did you do with your Christmas budget? Confession time for me: As I began shopping, I realized there were a number of things I left out of our 2009 Christmas budget. So we spent more than I hoped—but only with cash or debit card! And now we have a more complete budget for Christmas 2010.

Regardless of whether or not you avoided debt this Christmas, if you’re like most of America, you’re carrying an average of $10,679 in credit card debt (Nilson Report, April 2009, creditcard.com), as well as a hefty amount of student loans and a mortgage.

Don’t think debt matters? Consider this: Paying only the minimum payment on an $8000 credit card debt with an interest rate of 18% will take more than 25 years to repay and cost more than $24,000.

Not only does debt cost you more financially, but it can cause considerable emotional stress as well as strain your relationships. A friend told me recently that since she and her husband started following a budget with a plan to get out of debt, their fights were virtually eliminated.

Enter the debt snowball. Of course, for the snowball to work properly, you must stop accumulating debt. A budget helps tremendously with this. You must also have a $1000 emergency fund in the bank before you start snowballing. Why? Because if an emergency rears its ugly head and you have no cash in reserve, what will you default to? Credit cards. (You may even want to consider cutting up those credit cards at this point to remove the temptation…)

Here’s how to snowball:

• List all of your debts in order from the smallest balance to the largest, including the payoff balance and the minimum payment. (Save your mortgage until you’ve finished Baby Steps 3, 4 and 5.) Ignore interest rates at this point. Yes, mathematically speaking, it makes more sense to pay the debts with the higher interest rates first, but as Dave Ramsey says, good math isn’t what got you into this mess. The immediate gratification you get out of paying off the smaller loans will make you more likely to stick with it.
• Make the minimum payments on each of your debts, but pay extra on the smallest one. (Be sure to note on your pay stub that the extra should go towards the principal.) Is paying extra a stretch? Get mean: What can you and your family live without until you’re out of debt? Cancel your cable TV. Rent movies instead of going to the theatre. Eat beans and rice at home instead of dining out regularly. Avoid the mall like the plague. Take a few extra minutes and make your coffee at home instead of buying a $4 drink at Starbucks every day. I’m sorry to break it to you, but if you’ve racked up tens of thousands of dollars in debt, you don’t deserve a $4 drink at Starbucks every day. Cut out all of those extra expenses, and then have a yard sale. “Sell so much stuff your kids think they’re next!” Dave says. Finally, get creative and find some extra income. Clean house for your friends or neighbors. Mow lawns. Deliver papers before you go to your regular job, or pizzas after you get home.
• When you’ve paid off the smallest debt, add the amount you were paying on it to the minimum payment of the next smallest debt. Continue doing this until you’ve paid off all your debts and you are DEBT FREE!!!

With this method, your monthly cash flow remains the same, but as each debt is eliminated, the amount you are applying to your debts grows like a snowball rolling down a hill. (Hence the name.)

 
Example
Suppose your $10,679 credit card debt is broken down as follows:

After committing to making the minimum payment on all your debts each month, you scrimp and find an extra $100 per month. Add this to the minimum payment for your American Express credit card, for a total payment of $120 per month, and you’ll knock it out in the first month. You now have four debts left, with the following balances:

Now add the $120 you were paying to American Express to your JC Penney credit card, for a total payment of $145 per month, and you’ll pay it off in two months. The final payment will be only $80, so apply the extra $65 to your Macy’s card. You now have three remaining debts, with the following balances:

Apply the $145 you were paying to JC Penney to your Macy’s card, for a total monthly payment of $171, and pay this one off in three months. Your final payment will be only $15, so apply the extra $156 to Discover. You now have two debts, with the following balances:

Then apply the $171 you were paying on your Macy’s card to Discover, for a total payment of $206, and in another 3 months you’ll pay of the Discover card. Your final Discover payment will be only $187, so apply the extra $19 to Visa. You now have only one debt left, with the following balance:

Now apply the $206 you were paying on Discover to Visa, for a total payment of $306. At this rate, it will take more than two years to pay off your Visa. Now would be a good time to have that yard sale or get a side job!

At any rate, you see how it works. In just nine months, you paid off $2984 in debt and reduced your five debts to only one!

 
Different Approaches
This website, http://www.whatsthecost.com/snowball.aspx, allows you to enter all of your debts, their interest rates, and how much you plan to spend on paying them back. It will then calculate how much your debts are costing you in interest, how long it will take to pay them off, and what payback order makes the most mathematical sense.

It is true that if you are very disciplined, you will get ahead faster by paying off your loans in order from highest interest rate to lowest, but you should only use this approach if you are already highly motivated to eliminate your debt. For most people with a history of financial irresponsibility, the psychological reward of seeing the smallest debts paid off first is more beneficial than the math involved in paying lower interest rate loans first. Remember too that by paying the smallest debt first your snowball gains momentum faster. Moreover, the more minimum payments you eliminate will lower your monthly financial obligations and reduce your risk in the event of an emergency or lost job.
 

Snowballing vs. Consolidating
Debt is not a problem; it’s a symptom of overspending and under-saving. Debt consolidation treats only the symptom, not the problem. People who consolidate usually end up deeper in debt because they haven’t learned not to spend more than they earn. One debt consolidation firm reported that about 78% of the time, a client who consolidated his credit card debt will accumulate it right back.

Furthermore, debt consolidation costs you more in the long run. While it results in a lower payment, and perhaps even a lower interest rate, the term is extended so you end up in debt longer, meaning you pay the lender more interest. Dave Ramsey offers this example: Suppose you have a two-year $10,000 loan at 12% and a four-year $20,000 loan at 10%. Your monthly payments are $517 and $583, respectively, $1100 per month total. A debt consolidation company rolls your two loans into one and lowers your payments to $640 per month and your interest rate to 9%. Seems like a good deal, but now it will take you six years to pay off the loan, and cost an extra $5688 ($46,080, as opposed to $40,392 on the original loans). Debt consolidators make money off of you.

Snowballing is free, and it develops in you the character required for good money management. In order to treat the root problem, you must have a plan to stop overspending, pay cash for things, and save for the unexpected.

Questions or comments? Contact me here.

Other posts in this series:

• My Journey Towards Financial Freedom
• Dave Ramsey’s Seven Baby Steps
• How to Make a Budget That Works

Stay tuned for upcoming posts in this series:

• Myths About Debt: Why It’s Not a Wealth-Building Tool
• The Necessary Components of Every Financial Plan
• How to Calculate Your Net Worth
• Extra Wealth: This is What It’s All About!