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Debt-snowball method

by Cool mind | 1:48 PM in | comments (0)

The debt-snowball method of debt repayment is a form of debt management that is most often applied to repaying revolving credit -- such as credit cards.

Under the method, extra cash is dedicated to paying debts with the smallest amount owed.
This method has gained more recognition recently due to the fact that it is the primary debt-reduction method taught by many financial and wealth experts.

Methodology
The basic steps in the debt snowball method are as follows:

  • List all debts in ascending order from smallest balance to largest.
o 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.
  • Determine how much extra can be applied towards the smallest debt.
  • Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off.
o Note that some lenders 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.
  • 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.
  • Repeat until all debts are paid in full.
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.

It works as much on human psychology as it does on financial principles; 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.
  • 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.
  • 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 $245), 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 $295).

Thus in 15 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).
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. This will minimize costs to become debt-free faster than the smallest-balance approach.

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).

Debt consolidation vs loans

by Cool mind | 1:43 PM in | comments (0)

The multiple options available to consolidate ones debts can be quite confusing, credit counseling programs, debt settlement, debt consolidation loans, and bankruptcy are just a few options available today. Trying to find the best option to suit your current financial situation can be a difficult task.

Typically, debt consolidation programs are debt repayment programs. They can consolidate most types of unsecured debts from major credit cards to personal and student loans. You choose the accounts you want to enter into the program when joining. Once enrolled, the company will contact your creditors to negotiate more favorable repayment terms on your accounts and possibly reducing your interest rates and it may even eliminate late fees. You will then send that company one lump sum payment monthly which they will disperse to the creditors you enrolled on your account when joining.

Most so called debt consolidation loans are just home equity loans in disguise. They use the equity built up in your current home loan and use it to repay all of your unsecured debts. These types of loan options usually come with heavy application fees and can greatly extend the amount of time it will take you to pay off those debts. These loans also convert all of your current unsecured debts into a secured debt which is now backed by your home. If you fall behind on your payments you could risk losing your property.

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