subject: Debt Reduction - the # 1 Way of Eliminating Debt!? [print this page] Debt Reduction - the # 1 Way of Eliminating Debt!?
There are many different strategies for getting on top of debt. One popular technique is known as the debt snowball. The reason it's named 'debt snowball' is because you start with the smallest debt and work your way up to the biggest one, like rolling a snowball. When the first loan is paid in full you allocate the payment from this first loan to the next highest one. As each loan gets paid, the pay down amount getting applied to the next largest one gets larger each time - hence the term 'debt snowball'.
The reason this method is so popular is that paying the smallest debt off first gives you a quick win early on, giving you momentum and so you are more likely to stay with the plan.
Step # 1: List All Your Debts Starting with the Smallest Balance
List all your loans starting with the smallest balance first and ending with the largest balance. Credit cards, personal lines of credit, bank loans, student loans, car loans, 2nd mortgages (yes that's debt too), home equity lines of credit, overdraft credit lines are all included. The most distinctive feature of the debt snowball strategy is that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the one with the higher interest rate would be moved above in the list.
Step # 2: Only Pay the Minimum Amount on Each Debt
Find out from each lender what the smallest payment you can make on each loan is and only pay this minimum monthly payment. The reason you pay only the minimum amount on all other loans each month is so you can quickly pay off the smallest one first and not have to unnecessarily struggle to pay off all the others simultaneously.
Step # 3: Make Extra Payments on the Smallest Debt
For the smallest amount owed you determine how much extra you can pay off whilst maintaining minimum monthly payments on the others. (It is this step that differs with other debt reduction strategies, focusing on paying off quickly the smallest amount owed rather than the amount with the highest interest rate)
Step # 4: Once the Smallest Loan is paid in Full, Celebrate!
I don't think this step needs much explanation! Needless to say don't use any additional lines of credit to pay for your celebration!
Step # 5: Tackle the Next Smallest Loan
Now that the smallest loan is paid in full, you add the old minimum payment (plus any extra amount you were paying) from the first loan to the minimum payment on the second smallest one, and apply this new sum to repaying the second smallest.
Step # 6: Repeat until all is paid
Repeat the process with each subsequent debt. In theory, by the time the final ones are reached, the extra amount paid toward the larger debts will have grow quickly, similar to a snowball rolling downhill gathering more snow (thus the name).
Note: A first home mortgage is generally not included in the debt snowball method, but is instead paid off as part of a larger financial plan. Many financial plans recommend pay off home mortgages in a later step, along with any other debt which is equal to or greater than half of one's annual take-home pay.
Should One Make Retirement Contributions During the Debt Reduction Process?
Some financial advisors argue that all contributions are to be put on hold during the debt snowball, thus freeing up more money to make payments. However, if this is the case, it is recommended that retirement contributions should not be put on hold for more than 2 years. Others dispute this practice, citing the cost of compounding interest to be greater than the gains made from paying off debt. It's really your call to make based on your financial priorities.
Debt Snowball vs. Avalanche
There's a lot of debate over whether debt snowballing is better than other techniques such as the debt avalanche method (paying the highest interest rate loan first). The mathematics favor the avalanche, the psychology favors the snowballing. Should you have a $2,000 balance at 10% interest, and a $6,000 balance at 18% interest, it would make no financial sense to focus on paying off the lower amount first. So when there are large differences in the interest rate on each account then the snowball method would not make the most financial sense.
People with more financial discipline can make quicker headway by paying off the loans with the higher interest rates first. However, attacking the smallest loan first, whilst still maintaining minimum payments on everything else is a great strategy so long as you follow through on the plan and step up to the next smallest loan each time and knock those loans on the head for good!
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