As we continue our money basics series on Build Your Foundation, we will continue to build on the ABC’s of Basic Budgeting, as well as setting financial goals. One financial goal you may consider setting is getting yourself out of debt.*
Having debt can weigh heavily on your emotions and mental state of mind. With all of the different things that are currently on your plate, the stress of the debt and the overwhelm of how you will get yourself out of debt may be the straw that breaks the camel’s back and have you and your spouse choose to divorce and go your separate ways. As mentioned in previous articles, finances are one of the top reasons why couples choose to divorce. Not being able to find an agreement on how your household will work with a budget or work towards the same financial goals may cause the stress to be too much for the marriage.
For couples who choose to stay in the marriage and try to work through the financial issues they are currently disagreeing on or trying to resolve, this article will give you some thoughts on your household financial goal to be out of debt.
What are these different debt elimination methods? A few of the common debt elimination methods include the Snowball Method, Highest Interest Paydown Method, and the Consolidation Method. We will look at each of the three different methods.
THE SNOWBALL METHOD
You may have heard Dave Ramsey on his podcast talking about the Snowball Method. The Snowball Method is pretty simple. List all of your debts – credit card, lines of credit, loans, mortgage, EVERYTHING. And in this list, write the debt down from the lowest balance to the highest. For example, say you have a car loan for $20,000, 2 credit cards with balances of $5,000 and $12,050, and a line of credit balance of $1,200 which you used recently for an emergency car repair. The way you would approach the Snowball Method is by listing first, your line of credit, second, credit card with the balance of $5,000, third, the credit card with the balance of $12,050, and lastly, your car loan balance. How you approach paying down the balances is by paying the minimum payment required on all of the debt with the exception of the line of credit, which is the first on your list to pay off.
Every month, you pay the most that you can to the line of credit balance until you have paid it off. Once this is paid off, you then attack the credit card balance of $5000. Once again, keep paying the minimum payment for the $12,050 credit card and the monthly for the car loan but now all of your energy and any amount you are able to pay down goes to the credit card of $5000 as your goal.
The reason why the Snowball Method works is that once you pay one item off, you gain momentum and encouragement and want to continue your journey to being out of debt. I think I like the Snowball Method because it’s almost like writing something down on the to-do list and then crossing it off once you are done with the task. There is something mentally and emotionally satisfying about crossing something off.
HIGHEST INTEREST PAYDOWN
The next method is to pay down the highest interest rate accounts to the lowest interest accounts. The reasoning behind paying down the highest interest rate is that when you keep a balance on credit accounts, you are paying interest. The sooner you get rid of the balance, the sooner you stop paying the interest payment to the bank or lender. So, in taking the accounts listed above, let’s say the car loan is at a 3% interest rate, line of credit is 10.5% interest rate and the credit card with the balance of $5,000 is at 18% and the credit card with the balance of $12,050 is at 22.5% interest rate. In this method, you will work to pay off the $12,050 balance first, then the other credit card, third, the line of credit, and then lastly, the car loan. Many people find this method to not be as satisfying as the Snowball Method but you do end up paying less in interest so what you end up paying in total every month gets smaller and smaller.
The last method is the consolidation method. This is an overly simplified explanation of this method and I would highly recommend you consult a personal banker or a money coach before jumping all into ridding your debt with this method. Depending on how you approach this method, there could be potential negative consequences to your debt elimination goal.
Now that the disclaimer has been noted, there are a few different approaches to the Consolidation Method. One way is if you have a line of credit, whether a home equity line or an uncollateralized line of credit and you transfer the balance of all of your debt into this one account and pay as much as you can to the balance. All of the monthly payments you were making separately to the credit cards, line of credit, and car loan will now all be transferred into this one account and all of the payments you were making separately, you will pay the same amount but towards one account. The expectation is that the interest rate, especially on the home equity line of credit should be lower, and the lower the interest payments, the quicker you will pay down the debt.
Another way of consolidating debt is through the zero percent interest rate balance transfer offers you may be receiving in the mail. If you have a credit card with no balance on the card and you are given the opportunity to transfer other credit balances to this card at zero percent interest, this may be another option for you. What you have to note is that the zero percent interest is for a short amount of time and you will need to work hard at paying down the balance before the interest rate goes back to the normal rate of something super high.
Again, the Consolidation Method is a bit of a gamble for a multitude of reasons. When you are trying to get rid of debt, getting another credit account with more credit available to use, is not the most prudent way to get yourself out of debt, especially if you are not working on the underlying issue of why you got into debt and how you will work on the underlying reasons in order to keep out of debt.
The reason why we have debt is simple enough – spending more than you make and living off credit cards and credit lines in order to have the lifestyle you want to have or you want to project to others that you have. What is hard is to work on the reasoning of why the image you project is important and how to work towards being okay with not having that image and that this is better, even for a short period of time than the debt you carry. One way to help you from getting into debt again is to consistently working within your budget to stay in the black. Another way is to work with a money coach to help you stay in the black.
At Build Your Foundations, we are here to help you put together a budget, set goals and help you work towards getting out of debt and even working with you on how to work through some mindset items to help you grow in your financial knowledge as well as growing your financial balance sheet. If you have any questions or would like to sit with us, please contact us.
*This article will not go over how the wealthy use debt in order to continue to build wealth.