There is no faster ticket to financial freedom than being debt free. Having debt can weigh us down and keep us from making changes in our life for the better. Whether that be freeing up money to add to your retirement savings, taking a new role that you love but that involves taking a pay cut or even the improvement in your health from the reduced stress that comes with being debt free.
About a year ago I came across a book called the Total Money Makeover by Dave Ramsey. It was here that I first came across the Debt Snowball Method for reducing your debts. I’d always considered focusing on the interest rate the smart way to go about debt repayment. It seemed more financially savvy to me to focus on the dollars involved and interest saved. If you are paying more interest on one debt over another, why would you pay the one with the lower interest rate out first? Since discovering this new method I can see the advantage in paying off debts from the lowest to highest balance over focusing on the interest rate.
Paying off debts is a hard slog. When you see how many years and repayment periods are left it may seem like there is no light at the end of the tunnel and you will be paying them off indefinitely. The key to the debt snowball is building momentum. Building new habits is tough and we often need instant rewards in order to keep us working towards out goals.
When we want to lost weight we join a gym and closely watch the scales. It can be hard to stay motivated when those scales don’t budge in the beginning. If you lost a kilo that first week, it would help you stay focused and more determined on your weight loss journey. This is why the debt snowball can be so effective at helping you get on top of your debt. It focuses on knocking down the smallest and easiest debts to tackle first. With each debt repaid, you can see your progress a lot sooner than if you attempted to pay out a much larger debt just based on the fact that you were paying a higher interest rate.
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Before I go into the debt snowball method I want to mention another step that is equally important before starting your snowball.
BUILDING AN EMERGENCY FUND
Before attempting the debt snowball it is best for you to save an emergency fund. Dave Ramsey and a lot of other finance experts recommend having and emergency fund of $1000. I would suggest going a little bit further and aiming for $1500. In my experience if your hot water system goes or your car dies and needs an expensive repair $1000 doesn’t always cover your emergency costs. Just having that little bit more will give you piece of mind especially if two emergencies rear their head at the same time!
This $1500 is a reasonable savings buffer to help you in times of emergency when you would normally throw those amounts on your credit card. There is no point trying to pay down your debt if you are going to be wracking them up again and living paycheck to paycheck with no plan for unexpected expenses. You’re just going to end up back where you started.
And let’s face it, there are always going to be budget emergencies. Just like it rains on the weekend, there are going to be rainy days where your best intentions to budget are going to take a hit. Do what it takes to save up your $1500 emergency fund and ensure that it is only used for emergencies. If you have to dip into it because your had to replace a tyre or you have a dental emergency, the money will be there for you. Just be sure to save up your emergency fund again as soon as possible.
Once you have saved your emergency fund you can move onto your debt snowball.
THE DEBT SNOWBALL
With a few minutes of planning you can be well on your way to paying down your debt. Here are the four steps to use the debt snowball method:
Write down all your current debts in an excel worksheet or piece of paper (Exclude your mortgage, this will be tackled once you have paid back all of your consumer debt and saved a 3-6 months expense fund). Go back to your loan paperwork, online banking or credit card statements and work out what your current debt balances are for all outstanding debts as at today. Then, take note of what rate of interest you’re paying (for full awareness of your debt) and your monthly minimum repayment.
For the Australians out there, getting a current HELP loan debt statement is not possible as these are only sent out annually with your tax return. Instead, enter the HELP balance that was on your most recent Tax Assessment paperwork and make a note to update this when you get your next one.
Once you have written all your debts down, number them from 1, 2, 3 from the smallest balance to the largest. Debt Number 1, the smallest debt balance will be the one that you are going to pay off first and attack with your debt snowball. The last and highest debt balance will be the last.
Work out based on your current budget, how much extra on top of the minimum repayments you can afford to put on your smallest debt for that month. If your lowest debt has a minimum monthly repayment of $25 and you can spare another $100 a month, start paying the $25 minimum repayment plus the additional $100 repayment, or whatever it is that you can afford.
Continue to pay Debt Number 2, 3 and so on as minimum repayments. Continue to do this until Debt Number 1 is full paid off. If you get any additional income, a bonus for example, or you were under budget for the month putting that extra money as an additional top up payment on your Number 1 debt will help you knock it down even faster.
Once your smallest debt is repaid, take the minimum payment for Debt Number 1, in the example above, that would be $25 a month and add your additional repayments of $100 a month and add this to the minimum repayment for Debt Number 2 – your second lowest debt.
This means you will now be paying a much larger amount on your second debt – saving you significantly in interest and getting you to your debt free goal much quicker. If your monthly repayments for Debt Number 2 were $40 you will now pay the minimum amount of $40 plus the $25 and $100 you were using to pay of debt number one. Continue to do this until debt number two is paid.
Continue to do this for each of your debts in the snowball until the last one is paid off. For each new debt paid off you will be taking the past minimum repayments plus your additional repayment and carrying it forward to the next debt in your snowball. Like a snowball, the repayment for each will grow and pay off a bigger chunk of each debt as it grows and moves to your next biggest balance.
There are no short-term solutions to paying off debt. It is going to be a slow and difficult journey but one that will be well worth it. Imagine all the things you could be doing with your cash if you were debt free. Put a deposit on a house, go on that dream six month holiday. Maybe you want to start your own business or invest for your retirement.
Keep these dreams at the forefront of your mind! Every time you feel like giving up ask yourself if you are willing to give up on your financial dreams.
STOPPING THE DEBT CYCLE
Here are some tips to help you stay out of debt and to help you get to your debt free journey sooner:
- If you can’t afford it don’t buy it. Are you about to buy something on the credit card? Stop! Whatever you are buying you are paying a 19% interest amount on top each year that balance is left unpaid. Does that sale price look so good now?
- Cut up your credit cards. If you are the kind of person that can’t resist a good deal and doesn’t pay your credit card off in full each month it is time to cut those cards up!
- Stop trying to impress others. No one cares what brand clothing you wear. People are too worried about their own lives to focus on your daily outfit choices.
- Learn to be content with what you have. Do you really need a brand new $35k car on finance on your $50k salary when your current car works perfectly fine? Are you willing to pay x dollars every month for the next 60 plus months? In good times and bad – when you are unemployed, when you are trying to live on one income, when you decide to cut back hours at work to study for a new career – that debt is going to still be there.
- Stop going shopping! It’s surprising how little you spend when you avoid going to the shops unnecessarily. If you have endless emails from clothing shops or stores that tempt you unsubscribe from them! Instead of going shopping, meet a friend for coffee, read a book, watch a movie. There are plenty of hobbies that are much cheaper and more valuable uses of your time.
For tips on saving more money to help you free up cash for your debt snowball check out 11 Everyday Tips to Save Money.
What are your debt goals? Do you have a plan in place to become debt free? Are you using the debt snowball method to pay down your debt? Comment below your goals and wins to achieve financial freedom below 🙂