October 1, 2016

WHY THE DEBT SNOWBALL WORKS AND WHY YOU SHOULD CONSIDER IMPLEMENTING IT

A few years back, when I didn’t keep a budget, I paid for the big TV package and, with it, I had FOX Business. One Saturday night, I sat down to watch TV before bed and on came Dave Ramsey.  His opening was about living like no one else so that someday you can live like no one else. That stuck with me.

I looked around my apartment and saw a world that looked like everyone else. With it, I saw a future like everyone else. I decided I wanted to change. I had been blessed to have zero debt by two amazing parents who refused to allow me to have college loans.

However, my boyfriend at the time (now my husband) was drowning in $20,000 of student loan debt. We had heard the lines that this debt will teach responsibility and that ‘it was the average amount.’ He had the same as everyone else! Isn’t that fair?

We talked over the next few days and decided we were going to be different. Sitting down and looking over everything else felt overwhelming. We had no idea how to pay it all off.

Debt no matter what size it is causes stress. Debt, in essence, is owing more than what you have. Some people talk about debt like it is part of life, but the reality is there are very few people comfortable with owing more than they take in each month. We have all come to accept debt as normal for buying a home, but this is because the home is “supposed” to increase in value. Car loans, school loans, and personal loans don’t increase in value. Each value decreases with time, while the interest on the debt grows — along with the pit in our stomachs.

In order to change our future and to become the couple that lives like no one else, we had to make some radical changes. We stopped going out and we stopped buying new clothes, electronics and furniture. We socked away each penny that we made and stretched it to see how far it would go. Still, the balance never seemed to change.

The thing with paying off debt is that you have to feel like you are making progress. Hence, Dave Ramsey’s debt snowball. I don’t really know if he invented this term, but since he is who taught it to me, I want to give him the credit. The idea behind the debt snowball is to take your smallest debt and pay it off first and move up the line.

We took the school loan and realize that there were three different loans in one. The total amount we paid was divided up between all three. This is why we never saw a difference — $100 extra spread three ways doesn’t really show up.

So, we looked at all three loans, we ranked them from smallest to largest and then looked at the interest rates. The two smallest loans were carrying a 6.5% interest rate, while the largest was carrying a 2.5% interest rate. We chose to start with the smallest for two reasons: (1)we would have progress the quickest and (2) we were paying more in interest than we would make in the bank. Because the bank is paying so little and loans still cost more than savings brings in, the old adage “it pays to save” just doesn’t apply. We chose to stop saving and just keep paying.

For 15 months, we paid $1,000 a month on one loan at a time until each one was gone. By paying so much, the progress was quicker. Also, when they were gone, saving $1,000 a month became easy. We just started paying ourselves.

FINANCIAL BIN TIP: HOW TO PAY OFF DEBT

When you are thinking of paying off debt, there are a couple questions to ask yourself:

  1. Is this debt making me any money?  There are two types of debt: good debt and bad debt. A house usually increases in value and, if you stay long enough and keep it nice, you will make a nice return. Rental properties pay off their own debt. These debts are okay to carry for the life of the loan in many circumstances. Other debt such as school loans, car loans, and personal loans have no value or even lose value. A school loan got you an education, but after you get your first job, it becomes less valuable each year. Cars lose value each year that you drive them. Identifying whether the type of debt you have is good or bad will go a long in way in determining whether or not you need to commit to paying it off right away.
  2. Place debts in order from smallest to largest. This is what I learned from Dave Ramsey. Pay off the smallest first. You will feel a sense of progress.
  3. Move debt around based on the interest rates. If you are paying 5% on a $2,000 loan and 20% on a 10,000 loan, pay off the higher interest rate first.
  4. Is there a point to save right now? Depending on the markets, saving while having debt doesn’t always make sense. If the money in the bank is making 1% a year and having debt is costing me 5%, is it worth it to save $500 a month? Absolutely not! By saving you are losing a net 4%. When the debt is gone, you will have a gain of 1%. Get rid of the debt — not all savers are winners.
  5. Pay attention to the markets. Ten years ago, my Honda cost $21,000 and had an interest rate of 1.5% for 5 years. The bank was paying 6%  on a 4-year CD. Back then, the choice was made to take on the $21,000 in debt and keep the money in the bank. I was making more by saving then by buying the car flat out. Markets change, though. Today, it does pay to get rid of the debt!
Anna Domzalski is a staff writer for the Financial Bin. Anna will soon begin her role as Dean of Financial Bin University and will conduct online budgeting classes beginning in February 2012. She can be reached via email at Anna@FinancialBin.com.
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