Baby Step 2: Pay off all Debt using the Debt Snowball Method

The theory behind Baby Step 2 - Pay off debt using the debt snowball method is very simple which is why it really appeals to us. It's so easy to understand. You arrange your debts in order of current balance, lowest to highest and then pay them off in order from lowest balance to highest balance. As soon as the debt is paid off on the lowest balance that amount is added to the payment you were making on the next lowest balance debt. You continue to do this and as you do your snowball gets bigger and bigger with each debt you pay off and before you know it you're able to put some serious money towards your debts. I have to admit it's a pretty awesome feeling when you send $350 to pay on a bill that you used to only pay $300 on. One thing you really need to do is to stop incurring new debt! If you don't you'll never get ahead of the debt.

Let's take the following scenario. Let's pretend our friend Jack has the following debts:
Lowe's credit card, current balance $550 at 18% interest, $15.00 per month minimum payment. Jack didn't have his $1,000 emergency fund established so when his dishwasher went out he charged one on his Lowe's card.
Student Loan, current balance $6,800 at 6% interest, $100.00 per month minimum payment. Jack was lucky and only had to get a small student loan unlike some fellow students that were graduating along with $25,000 to $50,000 in student loan debt.
Visa credit card, $2200 at 12% interest, $50.00 per month minimum payment. Jack should have used the money from his $1,000 emergency fund to pay for the dishwasher but since he didn't have it he was going to use this credit card because of its lower interest rate but Jack's limit is $2500 which isn't high enough to cover the new dishwasher.

Now let's consider some pay off methods. We'll look at 3 of them. Method one - paying only minimum balance each month. Method 2 - paying lowest balance first (this is the debt snowball method). Method 3 paying highest interest rate first (this is typcally called the debt avalanche method). For this post we will stick with the basics and assume Jack isn't able to put any extra towards his debt. In a future post I'll show you how you can turbocharge your payoff. You'd be surprised how something as simple as adding an extra $10 per month will really get you out of debt in a hurry.

I used the iPad application Debt Strategy to come up with the values shown in the table below. One thing you will notice is that there's no difference between paying off the debt by lowest balance first and paying it off by highest interest rate first. I had read and used online calculators that show paying by highest interest rate first can get you out of debt faster but personally I think it takes a lot of discipline to use that method. Think about it if we had good discipline we probably wouldn't be in debt in the first place! While preparing this post I did run the same numbers through an online calculator and they agree with what the iPad application calculated so I'm confident in this scenario it doesn't matter if you pay off lowest balance first or highest interest rate first. Donna and I are going through this process now and we are taking the lowest balance first approach and we're on track to be debt free, except for house payment by Christmas 2012. What a wonderful Christmas present that will be!

Debt Repayment Method
Method	Pay Off Date	Total Interest Paid	Interest Saved	Pay Off Early By
Minimum Balance	Dec 2018	$2493.81	$0	0
Lowest Balance First	Feb 2018	$2430.35	$63	10 months
Highest Interest Rate First	Feb 2018	$2430.35	$63	10 months

In this example it may seem like saving $63 in interest really isn't that big of a deal and in the scheme of things it really isn't. What is important is to note that you'll be out of debt 10 months earlier. By using the debt snowball approach you've really given yourself a $1650 raise (10 months x $165 in monthly payments) and that doesn't even include any interest you may be earning on that money.

I really am a believer in the debt snowball but there's one vitally important thing you need to remember about it or any other method you use to pay off your debt. You'll only get out of debt if you STOP ADDING NEW DEBT! It does you no good to pay off a credit card and then start using it again. To get out of debt once and for all you need to pay off the balance on the card and then get rid of it.

Here's a little shocking stastic I'll share with you. When reviewing my FICO score I saw a figure that floored me. It showed that I have over $70,000 available to me to charge things on credit. $70,000 WOW! I had no idea. Honestly I'm not confortable with that so Donna and I will be closing almost all of our credit cards and store cards to bring that number down. While it's true that I don't have $70,000 in debt just knowing that a few pieces of plastic in my wallet give me the ability to get $70,000 in debt in a hurry if I really wanted to bothers me. We are currently closing all accounts that have a zero balance on them. This includes credit cards and store cards such as Best Buy, Target, etc. Donna knew I was really committed to this when I willingly turned over the Best Buy card.

Just to recap here's how you can get out of debt using the debt snowball:

1. You have to be committed to not take on any more debt. That's critical!
2. List your debts in order of balance lowest to highest
3. Pay minimum payments on all debts. If you come up with extra money apply it towards the debt with the lowest balance
4. Once the debt with the lowest balance is paid off take the money you were paying on that debt and add it to the minimum payment on the debt with the next lowest balance
5. Continue paying off and rolling over your payments until you've paid off your debt

Good luck!