Monday, January 14, 2008

Arming yourself: The Debt Snowball

Throughout my financial travels I've encountered a lot of advice. Most of it has been propagated by bloggers and financial planning portals, but a fair bit of it stems from financial self help books that I've borrowed, caught snippets of online or have been given.

The advice varies from fantastic to simply wretched. But I've never encountered something as controversial and interesting as the debt snowball. There are a lot of people who swear by it and state that it's saved their financial lives. But on the surface it appears to be a rather simple plan outlining how one is better off potentially paying lower interest rate credit card balances first instead of the other way around.

The opposite, more traditional method seems to be the most logical.

  1. Order your debts in descending order from highest interest rate to lowest
  2. Pay minimums on all debts, no matter how small the balance
  3. Throw everything you can possibly manage at the highest interest rate until it's sleeping with the fishes
  4. When the highest interest rate balance has been knocked out, focus on the next debt
It is after all what most good, nonprofit consumer credit counseling services do the second you walk into their lobby with a heavy stack of bills. So it stands to reason that it's the right thing to do. It'll save you more money over the long term.

But the debt snowball approach doesn't seem that logical at all.
  1. Order your debts in descending order from lowest balance to highest.
  2. Pay minimums on all your debts, no matter how high the interest
  3. Throw everything you can possibly manage at the lowest balance until it's sleeping with the fishes
  4. When the lowest balance has been knocked out, focus on the next debt
This is the point. Humans are not logical creatures the majority of the time, nor are we very patient. It's extremely difficult for someone to stay the course, especially if they see little or no progress immediately. Plans that require a lot of time to unfold and show results are typically plans that end up in the rubbish pail rather quickly.

The debt snowball takes this into account. It's main driving principle is that you're tired of all the collection calls, nasty letters and angry lenders. So you want results and you want results now. It uses this energy and directs it at your problem.

So instead of feeling like you're always on the defense, you feel like you're aggressively tackling your problems. You feel as if you're now in control of something, where as before you were merely muddling through.

Chances are you have one or two rather small balance credit card debts if you're in financial trouble with the big four (American Express, Discover, Visa and Mastercard). Mine has been a measly $200 department store credit card I obtained from Macy's two years ago to receive a discount on a sapphire bracelet.

The missus also has one in her name. A Lane Bryant card for a puny $330. Since these balances are so low, their minimums were $10 to $30 a month. It'd still take forever to pay them off.

If we employed the debt snowball method of paying off our balances, we could have seen two positive results immediately. There's no question that we could have paid off $530 in one swoop if we weren't directing every spare penny at our highest interest credit cards.

It would have given us some positive feedback to fuel our future efforts.

Beyond those two? The next lowest balance is a Bank One card for $1,368.86. That seems like a lot, but now that we've eliminated $530 of our debt we can direct all that Macy's and Lane Bryant energy at it. It'd be paid off within three months, maximum.

After that we'd have even more a month to attack our next highest balance. And so on.

We're going to begin our implementation soon. We've researched the matter and we've both agreed we're the type of people who desperately need the positive reinforcement that a debt snowball will provide us with. Not only that, but it'll give us goals to strive for.

Our game plan is as follows:
  1. Order our credit card debts from lowest to highest balance
  2. Commit to monthly minimums on everything to prevent further stains on our credit report
  3. Commit to our budget, including debt related agreements we've entered into
  4. Pay off the smallest balance first before even thinking about the second smallest balance
  5. Repeat until every last penny is paid for in full.
If we follow this model we'll have six of our eleven credit card debts knocked out by this time next year.

Versus three out of eleven if we follow the more traditional model.

So if you think the idea is a good plan for you, research the issue a bit more. If you think you're the type of person who'd benefit from this alternate model of paying off your debts, do so. Tell me how it works out for you.

Further reading:

Have you employed this method in the past? Do you have some criticism about this solution? Say so in the comments and I'll link back to your blog in my next post!


Joan said...

I did this to a lesser scale but w/o the benefit of guidance from a fancy book.

it worked out pretty well in the end of things. Really gave me the confidence to plow ahead.

Anonymous said...

I'm comfortable with my highest interest rate first plan. My monthly statements only look dented but i still know it's my best option.

Its hard to stay psyced up though. It takes a lot of effort.


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