Saturday, August 15, 2015

Debt Snowball: Eliminating Credit Card Debt

Sometimes paying off credit cards can make you feel like you are standing at the bottom of Mt. Everest staring upward.  Now, those of you outdoorsy types know that you don't just wake up one morning and say "Gee, I think I will climb Mt. Everest today!"  It takes planning and preparation.  The same goes for paying off credit cards.  There are a couple of different strategies that help greatly in this type of planning.

One of these methods is sometime referred to a "debt snowball."  I've also heard it called a "debt ladder."  Regardless of what you call it, this method is highly effective for paying off debt.  It can be used with regards to all of your debts, but for now, we will just look at your credit cards.

The very first step is to prepare to make a list.  You will access to your most recent credit card statements.  Write down the name of the credit card, the balance, the percentage of interest that you are paying on it, and the minimum payment.  Do this for each card.

Next, reorder your list.  The first card you should list is the one with the highest percentage rate.  The one with the lowest percentage rate should be the last one on your list.  Your list might look something like this:

      1. Department Store Card--$550--19.99%-----payment:  $25
      2. Airline Credit Card-----$4500--14.90%-----payment:  $75
      3. Credit Union Visa------$3300----7.90%-----payment:  $70
Now, the next step also requires a little bit of work on your part.  You need to figure out how much money you have leftover after paying all of your bills.  This includes those minimum credit card payments.  We will do more work on budgeting in the upcoming months, but for now, let's assume that you've calculated this.  For the sake of example, let's say that you find that you have an extra $200 each month.

You are to pay all of your bills, including all of those minimum payments first.  Then, you are to apply the $200 to the first credit card on the list.  That is the one with the highest interest rate.  The reason is because regardless of balance, that is the credit card that is costing you the most money each month.  You will continue to do this each month until you have eliminated credit card number one.

Once the first card has been paid off, move on to number two.  Now that you have paid off number one, you have $225 available.  You are no longer responsible for the $25 minimum payment, and you still have your extra $200 to use.  So, here's what you'll do.  Again, make the minimum payments on all credit cards, then make an extra $225 to the one with the highest interest rate.  Keep doing this until you have eliminated the balance on that card.  Using the above example, that frees up an additional $75 per month (eliminating the balance on credit card two).  Now you have a total of $300 per month to apply to the final credit card after you've paid the initial minimum payment.

Now, there are a couple of other things that you can do in order to maximize your effectiveness in paying off credit card debt.
  • Use all bonuses and tax refunds to pay off credit card debt.  I know this is harsh, but if you have credit card debt, you have somehow lived beyond your means, and you need to wipe the slate clean as quickly as possible.
  • Transfer balances to lower interest rate cards.  Calculate carefully.  Most of the time there is a fee for a balance transfer.  It may not really be worth transferring a balance to a lower rate if the fee is too high.  Also, this is not a green light to go a head and open more credit cards all willy nilly.  More credit cards can get you in trouble if you aren't very calculated and very careful, however; if used carefully, and researched well, doing a balance transfer could greatly speed things up.  I have used this method successfully, and it has saved me time and money.
One important thing to note is that while you are paying off your credit cards, they should not be in your wallet (see last week's post regarding the freezer method).  You should not be spending money on them, or you are sabotaging your own progress.  Also, there is one exception to the above method of ordering your debt.  If you have any credit cards with a low interest rate that is only good for a limited time (perhaps you took advantage of some special offer), you need to place that in the number one position.  If you don't eliminate that balance by the agreed upon date, the credit card company will charge you a higher rate, and most likely backdate that all the way to the time you took advantage of the offer in the first place.  That could be a very expensive error!

This method can be highly effective for paying off credit card debt.  One of it's strongest features is that it aims to eliminate your most expensive debt first.  Simply put, the card with the highest rate costs you more in interest per dollar charged than any other debt.  

The "debt snowball" also helps you to combat lifestyle inflation.   Lifestyle inflation, in its simplest terms, is the idea that when people have more disposable income, they tend to find ways to spend it (dinners out, entertainment, etc).  By reallocating the minimum payment dollar amount to another credit card after you've paid one off, you've prevented yourself from spending that money on something else. 

I just paid off a credit card, and only have one to go!  One more step on the path to financial freedom.  For those of you that are also working to pay off your credit cards, how is your progress going?

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