This is Week 2 in the 7 week series of Dave Ramsey's Baby Steps to Financial Peace. Last week I talked briefly about Baby Step 1: Build a $1,000 starter emergency fund. Baby Step 2 is pay off all consumer debt using the Debt Snowball Method.
Why is The Debt Snowball in Baby Step 2?
You would never go on a road trip without packing a suitcase or start driving without a destination (unless blind adventure is the goal). It would also be foolish to expect to arrive at the exact moment your GPS predicted. We need to factor in a buffer for traffic, construction, potty breaks, and the occasional wrong turn. Having $1,000 in Baby Step 1 first helps take care of the diversions and unexpected twists on your road trip to debt freedom.
A survey conducted by the National Foundation for Credit Counseling (NFCC) showed 64% of Americans don't have enough cash on hand to handle a $1,000 emergency expense. What happens to these people when their car needs repair or they crack a tooth eating popcorn while watching Star Trek Into Darkness over Memorial Day Weekend (yes, that really happened to me)? They turn to the emergency plan someone else has prepared for them: American Express, Discover, Visa, or MasterCard – the very debt products they are trying to get rid of!
We need Baby Step 1 to be a money-cushion for Mr. Emergency's unexpected visit that clears the runway for our get-out-of-debt plan that begins by using the Debt Snowball.
How does The Debt Snowball work?
The Debt Snowball focuses all your energy on one debt at a time. It organizes the process in an easy-to-understand manner and has been proven by behavior scientists to be the way people successfully pay off all their debt. (Click here for more about how lowest balance works better than highest interest rate).
How does the Debt Snowball work? It should be called the Debt Snowman but then people would be really confused. Imagine creating a snowman: You begin by packing a little snowball and start rolling it. Each time the snowball rolls over it picks up more snow and gets bigger and bigger until you are leaving wide tracks in the frozen grass behind you. The Debt Snowball takes the money from each paid-off debt and applies it to the next one on your list until you are paying hundreds of dollars towards your biggest debt instead of fracturing it between a dozen little debts.
The Step-by-Step Debt Snowball Process:
- Gather a list of all your non-mortgage debts
- Organize them from smallest balance to largest balance
- Pay the minimum payments on all of them
- Use any extra money you have to pay towards the smallest balance debt
- Continue this process until the smallest debt is gone
- Take the money you were paying on the now nonexistent smallest debt and apply it to the next one on your list
- Continue this process until all your consumer debts are history!
Example: John's debts
- $100 past-due cell phone with $15 minimum payment
- $250 Kohl's credit card with $25 minimum payment
- $1,000 Visa credit card with $50 minimum payment
- $5,000 student loan with $250 minimum payment
- $10,000 car loan with $400 minimum payment
John has a total of $16,350 in debt and he is tired of most of his monthly payments going to interest. Currently, it is costing him $740 a month to maintain the debt and will take him 17 years if he only makes the minimum payments. If he decides to keep paying the same amount, even when the balances and minimum payments go down, then he will be debt free in 24 months.
John is offered to help his brother paint houses during the summer and fall and will make an additional $400 a month. Instead of only sending his creditors $740 in minimum payments he will begin sending $1,140, applying every extra penny to his smallest debt. Using the Debt Snowball method he will have paid off the $100 past due cell phone bill and the $250 Kohl's card with some extra to throw at the Visa in the first month! This process will buy him a Debt Free Date in 21 months.
Why does The Debt Snowball work better than paying down higher interest rate debt?
The most efficient way to pay off debt would be to put extra money towards a debt with the highest interest rate. Would you believe it is also the leading cause for why people give up and remain in soul-sucking debt payments forever?
There is a variable that is missing for the mathematical equation: QuickWin.
Adding QuickWin to any long-term goal will increase endurance, and endurance is how marathons are won.
QuickWin is what energizes people to keep going, even when things get tough.
QuickWin is the magic pill that causes the Debt Snowball to work better than the mathematics of paying down highest interest debts first.
An unexpected side effect of The Debt Snowball
Imagine having paid off a handful of debts using the Debt Snowball Method (lowest balance). This frees up more room in your budget to pay extra on other debts. However, an unexpected side effect of the Debt Snowball is that you would have more cash available to you If something bad were to happen that costs you more than your $1,000 Baby Step 1. You would have more money to tackle an unexpected event instead of going back to soul-sucking debt products. You are more likely to maintain your ground because all those previous obligations no longer exist.
Are there any exceptions to The Debt Snowball?
There are a few things that will cause you to push pause on your Total Money Makeover.
Some of the things I talked about that would cause you to push pause on your debt elimination plan with the Debt Snowball were:
- Impending layoff
- Larger medical expenses
There are some other exceptions to pulling off a text-book Debt Snowball payoff of consumer debts (smallest to largest balances). Here are the three most common:
- IRS back taxes: The IRS has the authority to garnish wages without going through a court process. Negotiating a payment plan before they do this helps, but it is still a good idea to put them in the first spot of your Debt Snowball
- Settlement offers: Debts that you have not paid on for more than 6 months may be willing to settle the debt for less than is owed. If you can get a good offer in writing then wrangling up the cash would take prescience over the debt snowball items. Note: Do not give them electronic access to your accounts and it is recommended to send a cashier check or money order instead of writing them a check. They have been known to draft accounts for more than the verbal agreement – and there is little recourse when you owed them the money anyway.
- HELOC: If you have a 2nd mortgage or HELOC that is more than half of your annual income then it could take an extremely long time to finish Baby Step 2. In this situation we would recommend doing one of two things: Refinance both mortgages into one (click here to learn how to evaluate a smart refinance) or put it off until Baby Step 6 (pay off the house early).
Your homework today
Now that you understand the benefits of The Debt Snowball it is time to do some homework:
- Create a list of all your debts including Title, Amount Owed, Minimum Payment, and Interest Rate
- Write the list in order of smallest balance debt to largest balance debt
- Include the minimum payments in your monthly budget
- Extra money in your budget should go to a category called “Debt Snowball”. Use this to pay down your smallest debt
- Repeat this process every month until all consumer debts are gone
- Finally, negotiate lower interest rates for your debts.
Most people following these guidelines find themselves out of consumer debt in 18 – 24 months. Using QuickWin helps keep you working the plan and more people reach their goal than people using a Debt Avalanche process. Once you've completed Baby Step 2 using the Debt Snowball it is time to move on to Baby Step 3 (which I will talk about in next week's episode).
BONUS AUDIO mentioned in this episode: