By Roger G. Best
There are several different approaches to debt reduction, most of which have merit. Although this series of articles aren’t intended to be an exhaustive study of all the options, I do intend to cover the most accepted and successful methods, in order to give everyone a better understanding of the options.
The first widely accepted method is known as the debt-snowball method. Simply put, this method encourages applying extra cash to repaying the debt with the smallest amount owed. One of the biggest advantages it offers is in the form of personal satisfaction… You get to eliminate certain debt quickly, then apply that extra money to the next smallest debt, which will reduce the number of payments you have to make and begin to quickly reduce your overall debt. This method is widely accepted and taught by many experts.
Here’s how it works:
1) First, list any debt that you own in an ascending order from the smallest balance to the largest.
- Note that this method list your debt based solely on the total amount of the debt, and completely ignores the interest rate associated with each balance.
2) You commit to pay the minimum payment to every debt
3) Next, you decide how much extra you can afford to pay toward your smallest debt until it is completely paid off.
4) When you’ve completely paid the lowest debt, you then add the minimum payment, plus the extra amount that you’ve been paying, toward the second lowest debt on your list.
5) You continue this process until all debts are paid in full.
The theory is that as you pay each debt off and add that amount to the next debt, the further you get into the process, the amount will have grown substantially (much like a snowball grows as it proceeds down the hill).
Here’s an example to help clarify the process. Let’s say you have a total of $8856.70 in credit card debt.
- Total Balance – $567.25
- Minimum Payment – $22.00
- Total Balance – $625.45
- Minimum Payment – $25.00
- Total Balance – $1147.57
- Minimum Payment – $47.00
- Total Balance – $6516.43
- Minimum Payment – $245.00
Your total monthly payments for this debt are $339.00. If you decided that you could afford to apply a total of $400 per month to your credit card debt reduction, using the snow-ball method, you would pay the minimum payments to each card each month and add the extra $61 per month to Card 1 (lowest balance). That would put you paying card 1 a total of $83 per month ($22 minimum payment plus $61 that you can afford to pay extra). That would get card 1 paid off fairly quickly. Once card 1 was completely paid off, you would take the $83 per month that you’ve been paying to card 1 and add it to minimum payment that you’ve been paying for card 2. That would have you paying a total of $108.00 per month to card 2. If you continue that process to card 3, you’d be paying $155 per month to card three and finally $400 per month to card 4 when you get to the first three cards paid off.
I said in the second paragraph that this method has the advantage of offering personal satisfaction. It plays into our human psychology by paying the smaller debts first, you see fewer bill as more of the individual debt is paid off and causes you to feel better about reducing your overall debt, thus staying motivated to stick with the plan.
This particular method typically doesn’t include the first home mortgage and doesn’t account for the fact that larger debt often has much higher interest rates associated with them, especially as it applies to credit card debt. I’ll move on to other methods and continue to go deeper into each topic in my next installments.