## Tuesday, July 10, 2012

### How I Use the Debt Snowball Method

The Debt Snowball was made popular by Dave Ramsey, a personal finance author who writes about getting out of debt. If you haven’t read Your Total Money Makeover, I highly recommend it.

The purpose of the Debt Snowball is a way to help you eliminate your loans as fast as possible. There are two ways of doing this. By Amount and Interest. Let's look at both of them.

Amount

Write down your debts from smallest to largest. Then in the next column, write down your minimum payment on each debt. Once you have done that, total it up. Now, determine how much you can afford to spend extra paying towards your debt. Then you apply this extra money to the first debt on the list. Here is an example:
• Car loan: \$3,000 at 5.9%, monthly payment: \$75
• Student loan: \$10,000 at 6.8%, monthly payment: \$150
• Credit Card: \$15,000 at 16%, monthly payment: \$200
• Total monthly payments: \$425

So, you know that you need to pay a total of \$425 a month towards your debts. But you know you can pay a total of \$625. You take that extra \$200 and put it towards the first loan. Now your payments look like this:
• Car loan: monthly payment: \$275
• Student loan: \$150
• Credit Card: \$200
• Total monthly payments: \$625
By putting an extra payment towards the first loan, you can have it paid off within a year (according to my calculations at this lovely site). After the first loan is paid off, you still pay the same amount, only you now apply the excess money (in this case \$275) to the next lowest loan. Your payment on the student loan would now be \$425 and your payment on the credit card would be \$200. Once you have paid off the student loan, you take the \$425 and apply it to the credit card payment, bringing your payments on the credit card up to \$600. This method starts to snowball your debt, whacking them out faster and faster without a change in how much you are putting towards your debt each month.

Interest

Write down your debts from highest interest rate to lower interest rate, then repeat the steps above. This could take longer, but in this scenario you will actually pay less interest over time, which means you are saving money by not paying more interest than you would in the first method, but you might not feel that personal “victory” as early.

I am using the debt snowball method, but I also have a policy that if I come by any “extra” money during a given month (a gift, a \$5 bill in my coat), I put it towards my lowest debt. This is called a snowflake, because it is a small speck that will eventually make a larger snowball.

Luckily for me, I didn’t have to choose between the “smallest debt” or “highest interest” when ordering my debt snowball. My smallest debt also has the highest interest. Therefore, it is to my advantage to pay that off as quickly as possible. I have the peace of mind knowing I’m paying less interest AND I am on track to eliminate my lowest debt by early 2013!