The Basics of the Debt Snowball Plan
Financial Expert Dave Ramsey’s “Baby Steps Program” has been helping thousands of Americans dig their way out of debt to recognize financial success. He says step one of this plan is saving a “baby emergency fund” of $1,000. The second step involves actually getting out of debt. To do this, he says you follow the “Debt Snowball” plan, which is designed to build momentum and keep you just excited enough to succeed. We’ll discuss this in more detail in a minute.
After you pay off your credit debt, Ramsey advises that you bump up your savings so it covers three to six months of expenses, put 15% of your income into retirement, save a college fund for the kids, pay off your home early, become very wealthy and give back.
Video: Dave Ramsay’s Financial Advice
First, Create a List
Getting organized and facing the facts is the first step to recovery. Just as an alcoholic must stand up, recite his or her name and say, “I am an alcoholic,” so must you stand up and say, “I am a debtor.” Once you’ve put down the names of all your creditors, along with the due dates, current balances, minimum monthly payments and interest rates, you will be ready to begin your plan. Reorganize your list of debts from the smallest balance to the highest balance.
Next, Pay the Minimum Payments
Next you’ll send off a check to cover all the minimum monthly payments, perhaps $10 here, $25 there. This will keep your credit score buoyed while you repay debts. The best way to improve your credit score is to pay your minimum monthly payments on time. This will also prevent your interest rates from increasing.
Get Ahead With Extra Payments
If you really want to “attack, attack, attack,” as Dave Ramsey suggests, paying extra payments can aggressively lower your debt. By the debt snowball method, you will take your remaining funds after paying the monthly payments and apply it all to the lowest-balance credit card to get rid of it. When you’ve paid it off, you apply all your money to the next-lowest-balance, and so forth.
Other financial advisers recommend doubling all your monthly payments. Many people mistake this to mean double the dollar amount. They think, “Well if I’m paying $10/month on my $1,000 debt, I should instead pay $20/month to get ahead.” However, this approach would still take you 6 ½ years to pay off. Granted, that’s better than if you had just paid the bare minimum, in which case the interest would amount to $935, taking you 13 years to pay off! So if you really want to get ahead, double the percentage of the overall debt. If your credit card company charges a minimum monthly rate of 2%, you should double that to 4%. If you continue to pay off your debt this way, you’ll be debt-free in 2 ½ years.
Alternate Method: "Debt Avalanche”
While the Debt Snowball Method is psychologically better for some, experts say the Debt Avalanche Method is wiser, mathematically. Instead of starting with the smallest amount, you’ll instead start with the highest interest rate. It may seem counter-intuitive to begin with the highest interest rate, rather than the highest balance, because interest rates can drastically escalate your balance, whether you realize it or not.
Take, for instance, the case of Dennis Spaulding of Corona, California. When he purchased two last-minute plane tickets to attend his father’s funeral, the banks saw he was using a higher percentage of his available credit and considered him a liability. They raised his interest rate on four credit cards to 24%, which effectively doubled his monthly payments to an astounding $2,000!
Also, imagine you’ve got a 30-year fixed mortgage loan out. With perfect credit and the lowest possible interest rate (4.732%), you’ll be paying $562,320 for a $300,000 home. By contrast, with the worst credit (6.321%), you’ll be paying $669,960 over the lifetime of the loan, due to the interest! Why pay an extra $107,640 when you don’t have to? This is why experts say one of the best ways to get out of debt and start saving for your future is to pay off your house early – in 8 or 9 years, versus the traditional 30.
Video: Jean Chatzky’s Financial Advice
When In Doubt, Dig Out!
You may be wondering, “Well how can I set aside money to get out of debt, when I can barely make my monthly payments or cover my basic expenses?” If you find yourself in this sort of situation, these self-help methods will probably do you no good. You will need a financial counselor to help you dig out by lobbying on your behalf, lowering your overall monthly payment to an affordable level.
Consider debt settlement or consolidation if: you have seven or more credit cards and loans; your minimum monthly payments far exceed $25; your interest rates have skyrocketed 19% or higher; you have feel as though you’re not bringing in enough money to meet your obligations; you’re being harassed by numerous creditors; you have to ask yourself, “Which bill will get paid this month?”
EXAMPLE: Debt Snowball vs. Debt Avalanche in Action
Let’s say you have three credit cards to pay off. Your Visa’s up to $12,500 with an APR of 19.5% (you missed more than one payment), your Discovercard’s at $3,500 with 17.5% interest, your Sears store card is $800 and 19% interest and your Mastercard is up to $7,200 and 13% interest. Your total debt is $24,000.
Using the Debt Snowball Method, you would start by paying the $800 Sears card first, while making minimum monthly payments on the rest. Next you’d pay Discovercard, then Mastercard, then Visa. On a monthly debt budget of $1,500, it would take you 19 months to pay off the debt (including the $3,243 in interest.)
By contrast, using the Debt Avalanche Method, you would patiently hack away at your $12,500 Visa with the 19.5% interest. Next you would pay the Sears card with (even though the balance isn’t as high, the interest is), then you’d pay Discovercard, then Mastercard. Using this method, you’ll be out of debt in 18 months (including the $2,717 in interest fees.)