Pay smaller debts first using the snowball method and become debt free.
Racking up debt using a credit card isn't difficult to do. Each day we're bombarded with advertising and new products all vying for our hard-earned money, and it can be difficult to say no.
Statistics demonstrate just how much Australians overspend, with an average credit card debt of $4,570, costing the average cardholder an estimated $800 in interest per year.
Paying off credit card debts can be difficult, especially when the pressures of rent or mortgage repayments are added to the mix, but it's not impossible.
One of the most popular ways of paying off your mountain of debt is known as the 'debt snowball method'.
At its core it involves you paying off your smaller debts first before working up to the larger ones, but there's more to it than this. Read on to find out how you can apply it to your debt situation.
How does the snowball method work?
The snowball method involves you ordering your debts into a list from smallest to largest. Depending on your plan you may only wish to include debts such as credit cards, personal loans or line of credit loans rather than your home loan.
At no stage in the listing process do you need to worry about interest rates unless you have two very similar balances—in this case you pay off the higher interest balance first.
Once you've worked out your list you simply pay the minimum repayments on all of the debts except the smallest. For this debt you'll pay the minimum repayment plus an additional amount you can afford. You'll need to write up a budget to work out how big this amount will be.
Once this debt is paid you work to the next debt, and pay the minimum repayment plus whatever you were paying on the previous debt. You then simply repeat this for each debt, adding to your repayment amount and paying your debts off.
Before you start on this strategy you should establish an emergency account. There's more information on this below in the tips section.
Strength of the strategy
Many of the strategies touted by personal finance gurus will have you pay down the largest balance first or the balance with the highest interest rate first. This can work if you have the discipline to wait it out.
The snowball method works by providing constant motivation. You'll see your debts get paid one after the other, giving you the momentum to continue making your repayments and to reduce your spending.
The snowball strategy in action
Here's a simple snowball scenario in action. Let's say you have five debts which are a mixture of credit cards and personal loans.
After ordering them you've come up with a list of what debts you're going to tackle first.
Let's say the first debt is a credit card with a minimum monthly repayment of 3% of the balance or $30, whichever is higher.
Let's say for the sake of this example you're able to put an extra $60 a month towards paying this off in addition to the minimum monthly repayments due on the other debts. This brings your total monthly payment to $90 for this credit card.
Remember this is made up of:
$30 in minimum repayments
$60 in additional repayments
At an interest rate of 20% p.a., this $300 debt would cost $331 and take one year to pay it off. With your increased payment this would become only $306 and four months.
Once this is paid off you'd then move to the $450 credit card debt. Let's say this card has a minimum repayment of 2% or $10, whichever is greater, and an interest rate of 20% p.a. You'd then apply your repayments from the first card to this. This would become $100, which is made up of:
$10 in minimum repayments
$90 in repayments from your previous card
If you paid the minimum repayment this card would cost a total of $839 and would take seven years to pay off. Bumping up the repayment would bring the total cost of this debt to $464 and would take you five months, taking the total time to pay off $750 of debt in nine months.
You'd then apply this $100 to the next card, and repeat the steps until you paid off your final $1,700 debt.
Tips to make the snowball method work for you
Work out a budget with how much you can realistically afford to pay.
Take into account all of your income and outgoings. This helps you gauge where you stand and tells you exactly how much you can afford to spend on eliminating your debts. Writing a budget is beyond the scope of this article, but you can use a calculator to make it easier.
Open an emergency savings account.
Getting out of debt is based on the fact that you stop your spending while you work to pay your cards and loans off. One way you can be sure to avoid this is to set up an emergency account before you begin this strategy. Build this account up to $1,000 - $2,000 so if unexpected expenses crop up you don't have to pull out a credit card.
You can put this money in a transaction account so it's readily accessible, or you can put it in an online savings account and earn interest on the balance. If you open a transaction account with the same institution you'll even be able to transfer between the two accounts instantly.
Cut wasteful spending.
To maximise the amount you can spend towards paying your debt off each month get rid of spending which is unnecessary. Limit the amount you spend on entertainment each week, source cheaper services or products which you use on a regular basis, buy in bulk and do whatever else you can to minimise the costs of living.
Once you're debt free turn your debt payments into savings deposits.
If you're spending $1000 a month on paying your debts off, and you've recently become debt-free, put this $1000 in a savings account. The beauty about this is you won't miss it because you've already budgeted for it. Keep this up for 10 years and you'll have an account balance of almost $150,000 which earns interest. If you're nearing retirement age you may even want to send this into your super fund.
Don't use your cards.
The first thing that you must do in order to deal with the debt is to stop using your credit cards. If you keep making purchases with them you will not ever get to pay off your debt. Take them out of your purse or wallet and put them somewhere safe.
If you are disciplined enough to only use your credit card in an emergency then keep it on you , but ensure you only use it for emergencies where you do not have cash on you. Also, remember an emergency is car break down that needs a repair, not a late night shopping trip.