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The best way to get out of debt is the debt snowball method

From my article today on insideSTL.com:

In my last article I recommended using the debt snowball method out of the three choices presented because I believe you have a better chance of sticking with it. Below, is a more detailed look at this method with an example and also further discussion regarding the benefits and criticisms of using this method to reduce your debt. Check out FinanceDad.com until my next column appears Tuesday.

The basic steps in the debt snowball method are as follows:

* List all debts in ascending order from smallest balance to largest.

* This is the method’s most distinctive feature, in that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the debt with the higher interest rate would be moved above in the list.

* Commit to pay the minimum payment on every debt.

* Determine how much extra can be applied towards the smallest debt.

* Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off.

*Note that some lenders (mortgage lenders, car companies) will apply extra amounts towards the next payment; in order for the method to work the lenders need to be contacted and told that extra payments are to go directly toward principal reduction. Credit cards usually apply the whole payment during the current cycle.

* Once a debt is paid in full, add the old minimum payment (plus any extra amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new sum to repaying the second smallest debt.

* Repeat until all debts are paid in full.

In theory, by the time the final debts are reached, the extra amount paid toward the larger debts will grow quickly, similar to a snowball rolling downhill gathering more snow (thus the name).

The theory works as much on human psychology; by paying the smaller debts first, the individual, couple, or family sees fewer bills as more individual debts are paid off, thus giving ongoing positive feedback on their progress towards eliminating their debt.

A first home mortgage is not generally included in the debt snowball, but is instead paid off as part of one’s larger financial plan. As an example, many financial plans pay off home mortgages in a later step, along with any other debt which is equal to or greater than half of one’s annual take-home pay.

The issue of whether one should make retirement contributions during the debt reduction process is a matter of dispute among proponents of this method:

* Some argue that all contributions are to be halted during the debt snowball, thus freeing up more money to pay down the debt snowball.

* Others dispute this practice, citing the cost of compounding interest to be greater than the gains of paying off debt.

* Some compromise by arguing that retirement contributions should be reduced to only the minimum amount that the employer will match with an employee, but not eliminated completely.

* Many financial and wealth experts teach that this halting of retirement contributions should last no more than two years.

Simple Example

An example of the debt-snowball method in action is shown below

A person has the following amounts of debt and additional funds available to pay debt (the debt is listed with the smallest balance first, as recommended by the method.

* Credit Card A – $250 balance – $25/month minimum
* Credit Card B – $500 balance – $26/month minimum
* Car Payment – $2500 balance – $150/month minimum
* Loan – $5000 balance – $200/month minimum
* The person has an additional $100/month which can be devoted to repayment of debt.

Under the debt-snowball method, payments for the first two months would be made to debtors as follows:

* Credit Card A – $125 ($25/month minimum + $100 additional available)
* Credit Card B – $26/month minimum
* Car Payment – $150/month minimum
* Loan – $200/month minimum

After two months (presuming the person has not added to the balances, which would defeat the purpose of debt reduction), Credit Card A would be paid in full, and the remaining balances as follows:

* Credit Card B – $448
* Car Payment – $2200
* Loan – $4600

The person would then take the $125 previously used to pay off Credit Card A and apply it as additional payment to the Credit Card B balance, which would make payments for the next three months as follows:

* Credit Card B – $151 ($26/month minimum + $125 additional available)
* Car Payment – $150/month minimum
* Loan – $200/month minimum

After three months Credit Card B would be paid in full (the final payment would be $146), and the remaining balances would be as follows:

* Car Payment – $1750
* Loan – $4000

The person would then take the $151 previously used to pay off Credit Card B and apply it as additional payment to the car loan balance, which would make payments as follows:

* Car Payment – $301 ($150/month minimum + $151 additional available)
* Loan – $200/month minimum

It would take six months to pay the car loan (the final payment being $240), whereupon the person would then make payments of $501/month toward the loan (which would have a $2800 balance) for six months (with the last payment at $234).

Thus in 17 months the person has repaid four loans, with two of them being paid in a mere five months and three within one year.

Benefits

The primary benefit of the smallest-balance plan is the psychological benefit of seeing results sooner. Retirement contributions should start once your expected investment yield is higher than the next highest debt interest rate (generally 8% for a balanced portfolio).[1]

A secondary benefit of the smallest-balance plan is the reduction of total amount owed to lenders in a single month. This is a risk reduction in the event of a lost job or emergency.

Criticism

People with more financial discipline can get ahead quicker by paying off the credit cards and loans with the higher interest rates first.[2] This will minimize costs to become debt-free faster than the smallest-balance approach. Dave Ramsey, a proponent of the debt-snowball method, concedes that “the math” leans toward paying the highest interest debt first; however, based on his experience, Ramsey states that personal finance is “20 percent head knowledge and 80 percent behavior” and that people trying to reduce debt need “quick wins” in order to remain motivated toward debt reduction.[3]

The Debt-Snowball method is only for those on high enough incomes to be able to meet all the minimum repayment requirements on their debts. This method could instead lead to problems for those who are struggling to meet these minimum payments demands. In this circumstance, an individual should not be advised to pay creditors differing amounts as this could count as non-equitable repayment, leading to problems (e.g. with going bankrupt, or with maintaining non-equitable repayments over longer periods).

Tips on the bill consolidation process

You must understand that when you enroll in a bill consolidation program, your financial troubles will not come to an end magically. Although, you will be provided adequate help by the consolidation company you choose, but the process of consolidation needs some participation from your side too. The success of the program depends greatly on you.

These are a few tips you must follow to make the bill consolidation program a success.

1. You must choose the company wisely: The first thing that you must be careful about is choosing the right company for bill consolidation. Find out about the different companies by asking them questions. Ask them how much they will charge you and how their program works. Also, find out what kind of help they provide you with, to ensure your success.

2. You must avoid new debt: Do not take on new debt while enrolled in the bill consolidation program. This may hurt your chances of finishing successfully. This is because the new debt does not fall under the program and adding new debt would mean less money going towards your current consolidation plan, as you would need to pay something towards that new debt too.

3. Try to make your payments on time: When you are enrolled in the bill consolidation program, a fixed monthly payment is decided on by the company after they have evaluated your financial position. Since the monthly installment amount is decided on the basis of how much you will be able to afford, there is no excuse for not paying it. You may also be dropped from the program, in case you miss payments.

4. You should make sure that your creditors are paid on time: When enrolled in the consolidation program, your financial situation is assessed and a monthly payment is fixed accordingly. This amount has to be paid to the consolidation company every month and they pay it to your creditors, on your behalf. You must double check with your creditors every month to make sure that your creditors are receiving their payments, on time. This is because late payments to them will hurt your credit record not the consolidation companies.

5. Make sure that you stick to the program till the end: Do not expect things to be better immediately after enrolling into the program. Try not to quit the program before your debt is completely paid off. This must be kept in mind if you want to get full benefit from the bill consolidation program.

This is a guest post from Dorothy Ben Parker

10 ways to cut back on your spending and save money

I hope you enjoy this excellent guest article from David from moneysupermarket.com regarding various ways you can cut back on spending and save a ton of money.

Grocery shopping – it’s easy to go grocery shopping for a few items and come out of the store with a variety of other items that you hadn’t planned on purchasing. The temptation to make impulse purchases can be difficult to resist, particularly as special offers and reduced prices make it easy for us to convince ourselves that the purchase is necessary. In reality, this can be an expensive habit as you end up buying items that you neither needed nor desired before you got to the store. Whilst most people focus on the saving they made as a result of the offers on these items, you should look at the additional money you have spent on these items and realize that in reality you haven’t actually made a saving, you have spent more. To combat this there are a few things you can do. The first is to prepare a list before you go shopping so you know exactly what you are going to purchase from the store. This doesn’t just ensure that you don’t forget anything. Sticking to a list and avoiding anything not on the list is a good way of ensuring that you don’t buy anything that you don’t need. Another thing you can do which you may not have considered is to avoid going food shopping on an empty stomach. If you are feeling hungry you are more likely to be tempted to make impulse purchases! One further way that that you can reduce the amount you spend on your grocery shopping is to try the stores own brand products. In some instances you may try a stores own brand product and decide that you prefer the more expensive ‘known’ brand products but on many occasions shoppers have tried own brand products and either tasted very little difference in the quality of the produce or actually preferred the own brand product. Purchasing own brand products rather ‘known’ brand products is a good way of cutting back on your spending and saving money.

Other shopping – for any other items that aren’t grocery related you should strive to get the best deal possible. These are usually one off purchases such as electrical goods and clothes. Some items, particularly high priced items such as televisions can significantly vary in price from one retailer to the next. Spending an hour of your time to shop around might seem a bit boring but it can lead to huge savings., it’s important that you don’t settle for the first price you see. Shopping online is a good way of saving money on your shopping as you avoid traveling and parking costs. Many online retailers now offer free delivery so it is possible to make a saving this way. Another way to avoid wasting your money is by returning any items that aren’t suitable straight away (e.g. clothes that don’t fit). It’s easy to put off returning an item and what usually tends to happen is that you never get round to returning the item and it ends up being a total waste of money.

Financial services – whether it’s an insurance policy or a new credit card you are interested in, it pays to compare providers to ensure you get the best deal possible. There are a huge number of providers about and the prices for an insurance policy or the rates and conditions of a credit card can vary greatly from one provider to the next. For this reason it is vital that you shop around and spend time researching your options before making your selection. This advice also applies to things such as gas and electricity, mobile phone contracts and loans.

Hobbies – whilst I’m not suggesting giving up your favorite hobbies to save money, it is worth looking at whether or not there are any potential savings to be made. In many cases, it is possible to make a saving without having to sacrifice your hobbies. For example, those that love exercising and are a member of gym could perhaps consider canceling their membership and look to make use of the great outdoors. It’s possible to stay healthy on a budget without the use of expensive exercise machines. Or for those that love going to the cinema, avoid going at peak times when the prices will be more expensive and resist the high-priced snacks and drinks at all times.

Holidays – there are a number of things you can do both before and during a vacation to save yourself some money. Whether you’re looking at weekend breaks or all-inclusive 2 week vacations, there’s money to be saved if you stick to a few of these tips. The first tip is to book accommodation that is outside the main tourist area. By staying in a location that is 5/10 minutes away from the main tourist area you can save a significant amount of money. Many of these places will have good public transport networks which make getting into the main towns easy and inexpensive. A second tip is to avoid restaurants that are aimed solely at tourists. These will likely be expensive and may not reflect the local cuisine. Ask locals which restaurants they recommend; it’s likely that the restaurants that they suggest visiting will offer tastier food for less. A final point to consider is sticking to a daily budget. Before you travel research attractions that you will likely want to visit and look into what travel and eating costs may be. This way you can have an idea in your head of how much you will probably spend over the trip which can then be divided into a daily budget. This should also help avoid any issues with not having sufficient money for your vacation.

Driving – we all know that driving can be very expensive. It’s for this reason that it’s worth considering the following driving tips to lower your automotive costs. The first is to avoid driving short journeys and instead either bike or walk. Not only will this save you petrol, it will also benefit the environment. When you do need to drive, the way in which you drive can make a difference to the amount of fuel you use. Driving smoothly and steadily accelerating and breaking rather than suddenly is a good way of saving gas. Other minor things you can do include avoiding carrying any excess weight and ensuring tires are pumped up to the correct pressure. Whilst these things will only lead to minor savings, over time these savings will add up.

Vouchers and coupons – vouchers and coupons are now available for pretty much everything. Whether you are going out for a meal or buying clothes from the internet, you should always to check to see if there are any discounts available through the use of vouchers, coupons and discount codes. The stigma of using a voucher or coupon has diminished over the years and there are now more available than ever before so whenever you are planning any sort of purchase be sure to check beforehand that their isn’t a voucher or coupon available. With some of these vouchers and coupons offering 50% off or more, there are significant savings to be made.

Satellite TV – we all have a select few channels that we spend the majority of our time watching. If there are certain channels that you are paying for that you never watch then it is worth canceling those channels. Whilst this might only reduce your satellite bill slightly, it is worth doing as over time the amount you save will add up.

News – with the latest news now being available and easily accessible online for free, newspapers could now be classed as an unnecessary expense. Whilst there will be some that would rather read the news in a newspaper, for many it’s worth considering cutting out the costs of newspapers and reading the news online for free. Many of the best known newspapers have websites that include all of the same news that is in their newspapers so you won’t miss out on any of the latest happenings from around the world.

Family activities – it is often assumed that a fun-filled family day out is an expensive treat but this needn’t be the case. As well as taking advantage of vouchers and coupons as mentioned above which can reduce the costs significantly, there are a number of things that you can do that won’t cost you a cent. Taking the kids to the park and having a picnic won’t cost you much and you can take a few ball games with you that the kids will love. Most museums are free to visit and will be educational for the kids and galleries are also often free to visit. Those lucky enough to live near the beach can visit for free; once again you could take a picnic and ball games and perhaps take a kite. Finally, something as simple as going for a walk can be made fun with some imaginative games. Even if the weather isn’t great, raincoats and wellies will help keep you dry(ish) and the kids will enjoy splashing about in the rain!

Three different methods to get out of debt.

Please check out my most recent article over on insidestl

My past couple of articles explored the way our brains work in order to help you actively contemplate your purchases to prevent you from buying things that only satisfy the now, yet deprive you of future goals. But what about all that debt that you racked up before you knew what I’ve recently taught you? Below, I’m going to show you a few different ways you can get yourself out of debt and which way I recommend, so you can quit worrying about money and develop a plan to get out of this mess and on the path to financial freedom.

There are several ways you can attack your existing debt, but if you haven’t gotten your current spending under control, your attempts will be futile. Thus, you must commit to spending extra money on paying down debt, not buying more crap you don’t need. I would also like to suggest you clean house, and sell all of the crap you have that don’t use on a regular basis, but I will focus on this in another article.

What are your options to start getting out of debt right now or how should you attack your debt now? In general there are three methods; you can consolidate all of your debt and make one payment, you can pay off all debt by paying off high interest cards first, or you can use the snowball method and attack the smallest balance cards first then the higher balance cards after the smaller ones are paid off. Below, I will explore these three options and give you my recommendation.

Consolidating debt is probably not an option for most people as banks typically want some sort of collateral for the money they loan you to pay off all your cards. That is, they want some asset to hold on to of yours in case you default on the loan.  If you’ve got equity in a home, this would work as adequate collateral if it covered the loan. The problem with consolidation is that it instantly grants you access to all of that credit again, and considering you racked up all that debt once, you will probably do it again, and be in a much worse position than now in just a couple of years. The good side is that if you’ve got a bunch of high interest cards, you can lump all of those debts into one and get a much lower interest rate. The bottom line is, if you’ve been irresponsible with credit in the past you’ll probably do it again, don’t consolidate.

Paying off your debt by first paying down the highest interest rate cards first makes a ton of sense financially, but it probably doesn’t provide as much of an incentive to continue paying off debt as the snowball method does. Paying off the smallest balance cards first provides a snowball effect in that once you’ve paid off the smaller balance cards first, you then take that money you were paying on the first card and apply it to knocking out the next one and so on. Psychologically, the snowball method makes you feel a sense of accomplishment after each debt has been paid off, whereas just paying down high interest rate cards may feel more daunting and unachievable.

The key here is to choose a method that you will stick with, not necessarily what makes the most financial sense. As an accountant, when I first evaluated paying off high interest cards first, versus the snowball method, I thought the snowball method was stupid. However, I’ve since realized that was naïve, and you’re better off picking a method that will continue to provide you a visual incentive to keep going. In essence, the snowball method may cost you slightly more in the long run, but the chances are you will stick with it. My next article will go into further detail on the debt snowball method, as I believe it’s the best way to go for most people.

Strategic default: When to call it quits on your home that’s worth less than you owe

If your home is worth less than you owe on it you’re not alone, major media is estimating that 1 in 5 or 20% of homeowners owe more than their home is worth. So what the heck are you supposed to do if you’re one of those people? It could take years before you are back to owing just what the house is worth, in some cases this could be 10 years or more. This article will help those folks stuck in this situation figure out what they should do by helping people evaluate the positives and negatives of walking away. For many people, this financial decision alone could be the most important one they’ve ever made. It could be the difference in retiring 10 years earlier, or being able to pay for their kids college.

I’m going to start this discussion by dismissing the moral or ethical implications of walking away from a debt (I’ll save this for you to decide). Rather than focus on what is morally or ethically right to do in this situation, I’m going to focus on what makes the most financial sense. In doing this, I’m going to first show you the upsides and then the downsides.

Starting with the positives (this list may not be all inclusive):

• Get to live rent free anywhere from 3 months to up to 15 months. Typically people live in their house after the foreclosure process has begun before being evicted for around 6 months.
• You can pay off other debts hanging over your head with cash saved in not paying rent.
• Can go out and rent a much bigger and better place for less money than you are already paying.
• Instantly take the stress away of staying in a bad situation.
• Start building for a positive cash flow future.
• Chance to reevaluate what got you into this situation so you can avoid it next time.
• With so many people going into foreclosure, banks will likely have to lower their future standards for home ownership, making it easier for you to buy another home with a stained credit report.
• Banks often pay you to leave the house early. How about an extra few grand just to hand over the keys and leave after your 6 months is up? They would rather do this than fight you in court quite often.
• Millions of other people are doing the same, people will understand your reasons and not judge you as harshly considering the circumstances.
• Get out now so you can re buy earlier than others when your credit score is restored. If you’re able to re buy earlier, you’re probably going to get a better deal on real estate than those people who wait and default in a few years.
• It may be better for you to wait and file bankruptcy and start over, as quick as 2 years after bankruptcy people are eligible to qualify for a new home loan.

And now for the negatives (not all inclusive):

• Some states allow banks to file deficiency judgments to collect the difference in what you owed versus what your home sells for at auction.
• It may be more difficult to rent with poor credit. You may be required to put both first and last month rent down or you may not qualify to rent without a cosigner
• You may face a ton of collection calls
• You may lose a home that you really love and have a connection to.
• It will negatively impact your credit for certain.
• You may owe taxes for the months you don’t pay but still live in the property and even if the property remains unoccupied until someone else takes title.
• Bad credit could impact future job searches.

Depending on how far upside down you are, it often makes financial sense to simply walk away. If you’re smart about it, you can change your financial position from extremely under to owing very little to anyone in just a few short months. You have to be willing to move away from credit though, and start living life with just cash. You have to ask yourself how long will it take to bring your home value up to what the house is even worth. If you can do that quickly, than staying probably makes sense. If your home is worth 15% less than you owe, and you’re in other debt, you’re probably fighting a losing battle and would be better off walking away and taking the credit hit. You should consider bankruptcy as a way to start over.

In the future, if you’re married and don’t live in a community property state, it may make sense to put the home mortgage in only one spouses name, and put the other spouse on title. This way only one persons credit is ruined if you were to have default. I will talk about this subject in the very near future.

The above article should not be construed as advice, rather as opinion. Consult a professional for specific advice for your situation.