Spending down debt: The snowball effect
Mar 15th 2008 2:30PM
Updated Jul 3rd 2008 7:34AM
This repost is part of our series on strategies you can adopt to free yourself from burdensome debt.
Do you want to pay down debt, but aren't sure how to do it? One of the best methods out there is called the snowball effect. This strategy of paying off debt focuses on getting rid of your highest interest rate credit cards first, which makes a lot of sense from a financial planning perspective because you reduce your interest expenses the fastest.
Think of the snowball effect as slowly building up the size of a your snowball then getting the snowball moving faster and faster by pushing it down hill. To use this strategy you start by paying the minimum amount on all but your highest interest credit card. Then use every extra cent you can find to pay the greatest amount you can on your highest interest credit card.
When you get that card paid off, then continue paying the minimum amount you were paying on your second highest credit card plus the larger amount you were paying on the highest interest credit card.
Let me show you how this works. Suppose you have three credit cards that you've maxed out. Credit Card A charges 18% interest and has a balance of $1,000. Credit Card B charges 15% interest and has a balance of $2,000 with a minimum payment of $20. Credit Card C charges 12 percent and has a balance of $3,000 with a minimum payment of $35. In addition you have a car loan that charges 6% interest and a payment of $150 and a mortgage with a payment of $1,000.
I'll assume this debtor has a total of $1,500 to pay bills to get the snowball started. To keep this simple I'm not going to calculate interest, but that additional cost will slow down the payoff because balances will not go down as quickly as shown here.
Month one you would use the $1,500 to pay:
Credit Card A $295
Credit Card B $ 20
Credit Card C $ 35
Car Loan $150
After these payments the balances (not considering interest) would be:
Credit Card A $1,000 - 295 = $705
Credit Card B $2000 - 20 = $1980
Credit Card C $3,000 - 35 = $2,965
Month two you would make the same payments and the balances (not considering interest) would be:
Credit Card A $705 - 295 = $410
Credit Card B $1980- 20 = $1960
Credit Card C $2,965 - 35 = $2,930
Month three you would make the same payments and the balances (not considering interest) would be:
Credit Card A $410 - 295 = $115
Credit Card B $1960- 20 = $1940
Credit Card C $2,930 - 35 = $2,895
Month four you would pay off Credit Card A and any extra toward Credit Card B. Payments (not considering interest) would be:
Credit Card A $115 - Paid off
Credit Card B $200 (extra from Credit Card A after payoff - $180 plus $20)
Credit Card C $35
Car Loan $150
Month four your balances (not considering interest) would be:
Credit Card A $0
Credit Card B $1960- 200 = $1740
Credit Card C $2,895 - 35 = $35
You can see that in four months you'd already have one credit card paid off. Starting with month five your snowball grows to $315 (the $295 that you used toward Credit Card A plus $20 (the minimum you were paying on Credit Card B)). In about six months Credit Card B would be paid off and then you could grow the snowball again to $350 toward Credit Card C ($315 you were using for Credit Card B plus $35 (the minimum you were paying on Credit Card B)). When Credit Card C is paid off than you can add the $350 to your $150 car payment and get rid of that more quickly. Finally you can use the extra $500 to pay down your mortgage more quickly.
Of course, in order for this to work you must stop charging to your credit cards until you get them paid off. Once all your cards are paid off, if you want to use them and pay them in full each month that makes sense, especially if you have a good rewards programs.
After reading this post, one of my readers, Theresa Bolton-Lynch, contacted me about a money management tool that helps you pay down your debt even faster - including your mortgage. At first it sounded too good to be true. But, after take a closer look at it, I've named it the snow ball effect on steroids.
Lita Epstein has written more than 20 books including the "Complete Idiot's Guide to Improving Your Credit Score."