When you are in debt many times you don’t know how to start getting out of that situation. On the web you can find many methods on websites and blogs but in the end they don’t just have the result they promise.
They are like the different methods to lose weight or ways to get in shape, at the moment of truth they fail, either because they demand a lot of dedication or because the results are poor.
One of the methods to reduce the best-known and best-functioning debts is “the snowball of debt.”
The concept of “the snowball of debt” in personal finance was introduced by Dave Ramsey in his book ” The Total Transformation of Your Money. “
In some other articles I have already spoken about this method. Here I want to go into depth since I consider that the first and main thing to have controlled finances is not to have debts, or at least, start to end them.
In the first place we will see what it consists of.
How “Debt Snowball” Works
“The snowball of debt” consists of a series of very clear steps:
1. Make a list of all your debts, ordered by the least amount of money debt. You may have credit card debts, the car loan even some personal loans. In this step DO NOT consider the mortgage, in case you have it. Being a debt of such a long duration and with a low interest rate, at least lower than the debts of cards and loans, it is treated differently.
2. Assign an amount of your monthly income to the payment of the debt. A correct percentage, which will be a strong effort but will also accelerate the payment is 30% -35%. At least, don’t go down 25%. Yes, you must adjust your expenses and living standards to 60% -65% of your income to end your debt as soon as possible. Nobody said it was easy.
3. Make the minimum payments of all debts with the exception of the first one on the list.
4. In the first debt pay the maximum you can according to the money you have previously defined to pay debts. This way you will end it quickly and it will motivate you to continue with the rest of the debts.
Why is it called “the Snowball”?
Once you have fully paid a debt, you will have another one at the top of the list. And also a less debt in which you will be making minimum payments. Therefore the amount of money that you can apply each month for the payment of this first debt is greater.
Every time you pay a debt, the amount of money you can apply to the remaining debts is a little bigger, like a snowball that is growing more and more.
When you are done with all your debts, you can take that “snowball” and now use the money to save and invest.
An Example of “the Snowball of Debt”
Imagine you have 3 loans. A personal loan of 3,000 euros, a car loan of 8,000 euros and debts on a credit card of 6,000 euros.
You order the debts as follows:
- Personal loan 3,000 euros
- Credit card 6,000 euros
- Car loans 8,000 euros
The minimum payments of each of the debts are:
- Personal loan 100 euros
- Credit card 150 euros
- Car loan 250 euros
Therefore the minimum payments add up to 500 euros.
Your monthly income is 1,800 euros.
If you separate 35% of your income to pay off debts, you have 630 euros. You dedicate 500 euros to the minimum payments and the remaining 130 euros to the first debt.
Once the first debt is paid, the minimum payments are reduced to 400 euros but you continue to dedicate 630 euros to the payment of debts. Therefore, once the minimum payments have been made, you have 230 euros as an extra to dedicate them to the first debt.
And so on.
A Variant of “the Snowball”
I end up with a variant of this method that can be an extra advantage.
Basically, it works the same except that once the minimum payments have been made on all debts, the remaining money is not dedicated to paying the first debt on the list, but is deposited in a savings account, with the highest possible return.
Once the amount deposited in the paid account is 30% higher than the first debt on the list, the money is taken out of the account and the debt is paid.
In this way, you reduce the minimum payments each month and have more money to devote to your debts in the savings account.
Advantages and Disadvantages of this Alternative Method
This variant is less profitable than the traditional way. You will never find a paid account that has a higher return than the interest rate of a debt.
Still, why do I find this variant interesting? Because security is gained. If you use the traditional method it is assumed that you have formed a small emergency fund, of about 1,000 euros, for example in case things go wrong.
But in the event of an unforeseen expense, you must stop reducing the debts and put the emergency fund back in its place.
With this method you reduce that risk. You are paying debts and forming a larger emergency fund at a time.