Finance Globe

U.S. financial and economic topics from several finance writers.
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The Debt Snowball

Paying off debt is a concern for many consumers, and there are different opinions on the best way to go about doing it.

Mathematically, it makes more sense to first pay off the debts that have the highest interest rate, and thus, are costing you more money in the long run.

But, handling finances and debts is more than mathematics; human emotion is responsible for many of the financial decisions we make.

Feeling discouraged from making little progress, or lacking confidence in our abilities to eliminate debt can sabotage even the best intentions.

The debt snowball, a technique first popularized by Dave Ramsey, acknowledges the emotional needs of consumers who want to get ahead of their debt and takes a different approach than conventional methods.

First of all, being in debt can be very frustrating. And it may be difficult to stay motivated in paying off debt, especially for someone who has lots of it.

A debt-ridden consumer may be overwhelmed by the sheer number of creditors they owe money to, but quickly reducing that number proves the progress they're making.

With this positive encouragement, a consumer whose determined in paying off their debt may be more likely to stick with their debt-reduction plan until they are debt-free.

How to "snowball" your debt
First, save up a $1000 emergency fund. The purpose of this fund is to cover unexpected expenses that may come up while you're snowballing your debt, so that you won't have to put them on your credit card and run up more debt. You may feel like you're spinning your wheels and have a hard time making progress if you don't have enough cash saved to cover those surprise expenses.

You'll need to draw up a budget to see how much you can pay towards your your debt. When figuring out your budget, list only the minimum payments on all debts. Figure out how much extra you can pay towards your debts each month. You'll reserve that amount strictly for debt repayment, to get you on a fast-track towards eliminating it.

List all your debts, except for your house payment, from the lowest balance to the highest balance. This is the order in which you'll pay off the debts. Don't worry about interest rates on your debts, unless the balances on two accounts are very similar, then you can list the debt with the higher APR first.

Make the minimum payment on all accounts, except the lowest balance debt. You'll focus all your attention on paying off that lowest balance debt until it's down to zero. It may take several months to pay off that one, or you may be able to knock out a couple of small debts in one month.

When a debt is eliminated, go on to the next lowest balance debt. Add the minimum payment amount from the eliminated debt to the amount you can pay towards the next debt that is being "snowballed".

This means you'll have more money to pay towards your debts as individual debts are eliminated, so your payments amounts will grow to keep up with the larger debts that must be repaid. This gives the effect of a snowball gathering more snow as it rolls down a hill, thus the name.

You'll continue this process until all your debts are gone. You're likely to see results very quickly by starting with the smaller debts, and you'll have more confidence in your ability to manage debt, plus more money to use for debt repayment, by the time you get to your larger debts.

Criticism of the plan
As mentioned earlier, simple mathematics prove that you can save money by paying off the higher interest debts first. You'll get ahead of your debts faster by paying the higher APR account first if you have a manageable level of debt, are confident in your ability to handle your debts, and have a realistic plan to paying them off within a reasonable amount of time. (You're the only one who can decide what's reasonable.)

Support for the plan
The reality is that many frustrated consumers have found that the debt snowball works, and many financial experts recommend it. Paying off debts the conventional way can feel like chipping away at a glacier with an icepick. The debt snowball, on the other hand, doesn't keep you thinking in terms of the dollar amount owed, but rather the number of creditors owed. Receiving fewer bills from creditors each month can give you a larger sense of freedom from debt, and it can be easier to maintain your debt elimination plan when you feel more in control of your finances.

A secondary benefit of the snowball technique is that the number of debts, and the number of minimum payments you have to make each month will be reduced sooner. This could be very important in the case of financial hardship. It may be difficult to keep up with many different minimum payments if you were to lose income, but fewer minimum payments would amount to being able to get by on less cash if something were to happen.

Should you delay retirement savings while paying off your debt?
Some proponents of the program advise halting all IRA or 401k contributions so that you have more money to put towards your debts.

Some dispute this practice, citing that the benefit of paying off debt doesn't outweigh the loss of compounding interest.

Some compromise by arguing that retirement contributions should only be reduced to only the minimum amount that an employer will match an employee, but not eliminated completely. But many financial experts teach that this kind of halting of retirement contributions should not last more than two years.

What to do when your debt has been eliminated
Once you're free from debt, you'll have fewer expenses and extra money on hand. Use that money to start your real emergency fund of three to six months' worth of living expenses; the $1000 fund was just to help you stay afloat for minor emergencies until your debt was paid off.

Also, begin fully funding your retirement contributions to ensure you won't end up back in debt in your golden years. And to top it all off, start saving for the fun things you want, like pricey electronics or a vacation, so you can enjoy your money.

When you have money in the bank, you have the freedom to do what you want to do. And saving money is the only way to get through life without borrowing money. With proper financial planning and a lot of discipline, you can reduce or eliminate the need to use credit for your needs and desires and never having to worry about how to pay off your debts again.
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Sunday, 21 April 2024

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