So you've created your budget, listed out all your monthly expenses and you notice, like many of us do, you've racked up a lot of debt. Student loans, credit cards, and mortgages seem to be the main culprits when I talk to people about their makeup of debt. You're ready to do something about it, but where do you begin?
A systematic way of paying down debt including financial wins along the way is what you need. What are you talking about Tiff? Well, there are two methods of debt payoff I like called the Debt Snowball Method and the Debt Avalanche Strategy. I think the debt snowball method is the easiest to do, especially if you're new to financial management (stay tuned for my post on debt avalanches). Besides, snowballs are safer to handle than avalanches anyway right?
What's this method all about?
I want you to picture yourself outside in the snow just for a moment (ugh Tiff it's just starting to get warm here in Michigan). You're about to build a snowman so you take snow and pack it into a ball. Then you begin to roll that snowball around to build it to the size of the base of the snowman. That's the idea of the debt snowball method. You pay off debts in order from smallest to largest. There are built in financial wins - you see your debt being eliminated one by one. This keeps you wanting to go until it's all gone.
Do you want to build a snowman? The debt kind of course!
Before we begin, make sure you’ve budgeted enough to cover the minimum monthly payment for every debt. You must continue to pay the monthly minimum payments on all your debt. Next, arrange all of your debts by balance, from smallest to largest. Disregard the interest rate on each. Every month, put the extra money you budgeted for getting rid of debt toward your smallest debt. Once the smallest debt is repaid, take the entire amount you were paying toward it (monthly minimum plus your extra money) and target the next smallest debt.
Pretend you have the following debt:
Credit Card 1 - $2500 (@ 13.5%): Monthly payment $65
Credit Card 2 - $3000 (@ 19.8%): Monthly Payment $85
Student Loan 1 - $7000 (@ 5%): Monthly Payment $80
Student Loan 2 - $5500 (@3.5%): Monthly Payment $70
Medical Bill - $500 (interest free); Monthly Payment $45
Using the debt snowball method, you would put them in the following order, paying off the medical bill first. Again, we are ignoring interest using the debt snowball method.
1) Medical Bill - $500 (interest free); Monthly Payment $45
2) Credit Card 1 - $2500 (@ 13.5%): Monthly payment $65
3) Credit Card 2 - $3000 (@ 19.8%): Monthly payment $85
4) Student Loan 2 - $5500 (@3.5%): Monthly payment $70
5) Student Loan 1 - $7000 (@ 5%): Monthly payment $80
Now that we have the debt in order, let's say using your budget, you see you have an extra $50 to put towards these debts. You would begin paying $95 a month to your medical bill ($45 original payment plus the $50 of extra income). This means that instead of paying the medical bill off in roughly 10 months, you've taken that down to about 5 months aka a faster payoff! Once the medical bill is paid off, you take the entire monthly payment of $95 and tack that on to Credit Card 1, so the new monthly payment is $160 (original $65 plus the $95). See how the monthly payments from debt paid off continues to snowball and go towards the next debt?
I like this method because it's easy to begin seeing your financial plan actually working. If you're a numbers person like me, this method might give you a little anxiety because you're ignoring interest, but this method is all about fast payoff rewards.