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Debt Consolidation Facts

1. If you spend more than 50% of your credit limit every month, this indicates to the Credit Bureau that you do NOT have enough cash on hand to meet your monthly expenses. This will identify you as a high credit risk and will actually reduce your credit score by 60 - 70 points overnight (Fair Isaac).

2. If you miss 1 or 2 payments on your credit card debt, the issuing company will skyrocket your interest rate to a whopping 27% - 30%!

3. Out of a random sample of 3 million American consumers (included in Experian's National Score Index), 51% of them have at least 2 credit cards and 14% of them have 10 or more credit cards.

2 Ways to Achieve Debt Elimination - Debt SnowBall Elimination Method

(April 23rd, 2007)

If you read our article on Do It Yourself Debt Reduction, we presented the following example:

Peter has an after-tax monthly take home pay of $2000. After paying off all his expenses every month, Peter has $450 remaining to pay off any debts owed. He should therefore allocate this $450 towards paying off debt that has the highest Annual Percentage Rate (APR). This is the fastest way to reduce your debt.

For instance, imagine you as a college student owe the following hypothetical debts (in random order):

$18,000 Student Loan @ 8% APR
$12000 Credit Card Debt @ 18% APR
$6000 Car Loan @ 7% APR
$3000 Personal Loan @ 13% APR
$1500 Furniture Purchase Loan @ 10% APR

Most Debt Consolidation & Financial experts will recommend to pay off the above Debts in the following order:

$12000 Credit Card Debt @ 18% APR
$3000 Personal Loan @ 13% APR
$1500 Furniture Purchase Loan @ 10% APR
$18,000 Student Loan @ 8% APR
$6000 Car Loan @ 7% APR

As you can decipher from the table, most financial experts are asking you to pay off Debts that have the highest APR FIRST. The $12000 credit card debt has the highest APR of 18%, followed by $3000 personal loan with APR of 13%, $1500 furniture purchase loan with 10% APR, etc. This makes perfect sense mathematically. By paying off debts with the highest Annual Percentage Rate (APR), you are minimizing the interest charges you will pay over the longer term. However, does this method work for everyone? No!

I once owed $12000 in Credit Card debt that had an APR of 18%. I was making $500 per month payment towards it, although psychologically, I felt i was making no progress at all! I was paying $500 per month for many many months and the debt didn't seem to come to an end at all! This made me felt more depressed and financially defeated. I'm sure there are thousands of Americans out there who are in the same boat. We as human beings like to make progress at each step of our lives, and paying $500 per month for many months didn't seem right! This is because the debt was always there, it didn't seem like the debt would vanish away anytime soon.

Debt SnowBall Elimination Method

Dave Ramsey introduces the idea of a Debt SnowBall Elimination Method in his book, The Total Money MakeOver. With the Debt SnowBall method, you ignore the Annual Percentage Rates (APRs) on your debts when determining which debt to pay off. Instead, you sort your debts from the lowest to the highest, an example is shown below:

$1500 Furniture Purchase Loan @ 10% APR
$3000 Personal Loan @ 13% APR
$6000 Car Loan @ 7% APR
$12000 Credit Card Debt @ 18% APR
$18,000 Student Loan @ 8% APR

The Debt Snowball elimination method says you should make the minimum monthly payments against all debts, except the smallest debt. In the above case, that would be the $1500 furniture purchase loan. After careful budgeting and cutting down on unnecessary expenses, you should put every dollar in paying off that $1500 loan. Once that loan is paid off, the Debt Snowball method tells us to move on to the next smallest debt, $3000 Personal Loan @ 13% APR.

One morning you wake up and find out that your $1500 furniture debt has been fully paid off and you no longer owe it. This would make a person feel very happy and psychologically motivated to pay off his next debt. On the other hand, the Highest APR to Lowest APR debt elimination method would take many months if not years, for the debt to be fully paid off. Dave Ramsey says it is very important to be motivated to pay off your debts, in what order you do this has no meaning.

Critics of the Debt Snowball Elimination method complain that in the long run, a person using this method will have paid more in interest charges & fees than a person who uses the Highest APR to Lowest APR method. This is absolutely true. However, it is easy to feel discouraged by the Highest APR to Lowest APR method because it can take literally years to pay off a particular debt. Your behaviour is more important than the Math, as Dave Ramsey puts it.

In conclusion, here's a step by step list of how to approach Debt Elimination via the Debt Snowball method:

  1. Sort your debts from the Lowest balance to Highest balance.

  2. Set a certain monthly payment schedule to pay off each of your your debts
  3. After careful budgeting, pay the most amount of money you can towards the debt with the Lowest balance owed.
  4. Make the minimum monthly payments on all the other debts, except the one with Lowest balance.
  5. When the lowest balance debt is gone, do NOT change the monthly payment schedule you created in Step #2. Instead, pay off as much as you can towards the debt with the 2nd Lowest balance.
  6. Repeat these steps for all Debts owed.

So, Debt SnowBall Method or Highest APR to Lowest APR Method?

So people, if you were in the above situation and owed all these debts, in what order would you pay off the debts? What's your reasoning behind it? What do you think are the pros and cons of applying both these methods, and which method would YOU use? You can contribute to this discussion by filling out the Comments box below. Please join in!

$1500 Furniture Purchase Loan @ 10% APR
$3000 Personal Loan @ 13% APR
$6000 Car Loan @ 7% APR
$12000 Credit Card Debt @ 18% APR
$18,000 Student Loan @ 8% APR

Comments

Jennifer Comments on June 21st, 2007

After becoming a Dave Ramsey fan, I don't believe in debt anymore. For me, any debt is too much debt! And I should know, we have almost $40,000 of debt which we are trying to pay off! I just started a blog at www.findingfinancialpeace.blogspot.com

Caro Comments on April 30th, 2007

I would probably pay off the loans in the following order:

$1500 Furniture Purchase Loan @ 10% APR
$3000 Personal Loan @ 13% APR
$12000 Credit Card Debt @ 18% APR
$6000 Car Loan @ 7% APR
$18,000 Student Loan @ 8% APR

My reasoning is that the first two are small enough that I can see a quick emotional return on paying it off, while the last two are significantly lower interest than the Credit Card debt, so I can wait. Plus, there is the fact that Student Loans (depending on lender) can be put on hold (not without penalty, of course) should you become unemployed or have some other problem making payments.

My completely logical mathematical standpoint is tempered by a desire to get what I think of as small debts out of the way quickly.

But there is another factor here that is not mentioned. Minimum monthly payment. When a person is nervous about their future financial stability, one thing they may want to do is to quickly pay off the debts that require a higher minimum monthly payment. The reduced monthly minimums can mean the difference between penalties and late payments during times of financial hardship. Paying off Credit cards tend to be a good way to do this quickly (and are usually the best bet from a highest interest rate perspective) because the minimum payment is reduced for each payment, generally.