In the FinancialVerse, debt has a substantial impact on most American households. In certain instances debt can be your friend, while at other times it can be your financial enemy.
Many families find that after they pay their mandatory monthly debt service, little cash is left for basic living expenses. We as consumers have accumulated more debt than we can handle. On May 14, 2019, The Federal Reserve Bank of New York’s Center for Microeconomic Data issued its Quarterly Report on Household Debt and Credit, which shows the total household debt has increased by $124 billion (0.9%) to $13.67 trillion in the first quarter of 2019.
Highlights of that report include:
Mortgage balances rose to $9.2 trillion.
Non-housing debt increased to $4.47 trillion, including:
Outstanding student loan debt increased to $1.49 trillion
Auto loans increased to $1.28 trillion
Credit card balances fell slightly, to $848 billion
We all need to reduce our debts and the negative impact it has on our monthly cash flows. One effective debt reduction method is called the Snowball Strategy and often proves successful for many people versus other methods (such as paying off the highest interest rate debt first – which is often referred to as the Avalanche Strategy).
The Snowball Strategy is based on paying off the accounts with the smallest balances first, usually revolving credit card debt, while paying the minimum payment on larger debts. Once the smallest debt is paid off, a person then proceeds to the next slightly larger small debt above that, so on and so forth, gradually proceeding to the larger ones last.
The basic 6 steps in the debt snowball method are as follows:
List all of your debts in ascending order from smallest balance to largest. This is the strategy's most distinctive feature, in that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the debt with the higher interest rate would be moved above on the list.
Regularly pay the minimum payment on every debt.
Determine how much extra can be applied towards the smallest debt.
Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off. Note: Some lenders (e.g., mortgage lenders and car companies) will apply extra amounts towards the next payment; in order for the method to work, the lenders need to be contacted and told that extra payments are to go directly toward principal reduction. Credit cards usually apply the extra amount in excess of the minimum to principal the during the current cycle.
Once a debt is paid in full, add the old minimum payment (plus any extra amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new sum to repaying the second smallest debt.
Repeat until all debts are paid in full.
In theory, by the time the final debts are reached, the extra amount paid toward the larger debts will grow quickly, similar to a snowball rolling downhill gathering more snow.
The Snowball Strategy works based on positive reinforcement human psychology; by paying the smaller debts first, the individual, couple or household sees fewer bills coming in as more individual debts are paid off, thus providing ongoing positive feedback on their journey towards eliminating their debt.
Summary
The Snowball Strategy’s primary benefit is the psychological benefit of seeing results sooner, in that you see tangible reductions in both the number of creditors owed (and, thus, the number of bills received) and the amounts owed to each creditor. Working to repay debts needs your attention. The negative impact of debt on household budgets, the importance of saving for emergencies and investing for future needs cannot be ignored. The Snowball Strategy may help you get out of debt faster. Give it a look as you manage your financial affairs.