Tuesday, June 9, 2009

The Power of the Snowball – Part 1

Photo: redjar

With the weather finally warming up here in Minnesota and the danger of frost hopefully behind us now, you may wonder why this post even references the word snow.

If you’re familiar with Dave Ramsey, you’ve probably heard of the Debt Snowball concept. The basic idea is to pay off your smallest debt first, then use the monthly payment that you had been paying on that debt towards the next smallest debt, and so on, until you’re eventually debt free. As each debt is paid, you have more and more money to apply to the next debt…thus – the snowball effect.

Here’s an example of how to leverage the power of the Debt Snowball.

Let’s say you have the following debt:

  • $5k in credit card debt ($100/month)

  • $10k student loan ($400/month)

  • Car loans (2 @ $500/month each)

  • Mortgage ($1,000/month)

  • 2nd Mortgage ($500/month)

That’s $3,000/month in total payments. In this example, let’s say you are able to come up with an extra $500/month to use toward your debt after all the minimum payments are made.

To start the debt snowball effect, you would pay $600/month toward the credit card debt ($100 regular payment + the extra $500) until you have paid off the smallest debt. Assuming a static $5k (i.e. cutting up the card), at a 15% interest rate, you’ll be paying $100 a month for the next 6 ½ years before your balance is paid off. However, paying $600/month towards the balance will retire this debt in just under 9 months.

Accelerating your repayment of the smallest to largest debt not only builds up momentum, but it also gives you quicker gratification that you are truly making an impact.

Once the credit card debt is paid off, then you would move on to the next smallest debt – the $10k student loan. At a rate of 5%, you’d be paying $400/month for over 2 years before your debt is paid off. With the Debt Snowball method, you would pay $1,000/month ($400/month regular payment + $100/month former credit card pymt + the extra $500), thereby paying off the student loan in just over 10 months.

Next, you would move on to paying off your car loans. Instead of making the combined $1,000 in minimum payments, you would make a total of $2,000 in payments ($1,000 regular payment + $100 former cc pymt + $400 former student loan pymt + the extra $500). If you had one car loan with a smaller balance, you could focus on paying off that one first, and then move on to the next.

Whether it’s an extra $500 or some other number, every dollar of excess cash available to apply to the Debt Snowball makes a drastic difference in how quickly you can accelerate your debt retirement.

Coming Up: In Part 2, I’ll tell you about some tools for implementing the Debt Snowball and what you will gain from it. Later, I’ll share tips on how to find excess cash to apply to the snowball each month. Stay tuned!

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