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.

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

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

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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.

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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.

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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.

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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.

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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).

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