Saturday, 1 January 2011

The “Money Makeover”– Milestone 2: The Debt Snowball

At this point, we should have created our budget, allocating savings and have our emergency fund 1 to prevent surprises and naturally cutting expenses where we can.

So, what’s the next step? Well, we really need to own our responsibilities and clear our debt.

What is the "Debt Snowball”?

Put simply, it is a list of all of the debt that we have. Loans, credit cards, money owed to friends/family, overdrafts whatever. The only debt it doesn’t include is the mortgage.

The aim of the snowball (at a high level) is to simply provide some visibility and focus on the money that we owe to other people. As you can see, a central theme to our makeover is removing surprises and setting expectations of our money.

As people in command of our cash, we should always clear debt before having our own fun with our cash (and we never borrow again once we have cleared it).

Why have a “Debt Snowball”?

For me, I love the idea of the snowball for the following reasons:

  • It’s simple. Always KISS.
  • It gives me clear success criteria. A requirement for any real project/task. Once a debt is cleared, you can cross the item off the list.
  • It provides focus. Again, we need to focus on important things to get them done quickly and efficiently.
  • It provides a mechanism for “gearing”. If you have a lot of debt, owed to a lot of different people, things can get overwhelming. You can have a lot of little fish nibbling away at you as well as the big sharks. This can be really overwhelming. The snowball allows you to focus on one enemy at a time and systematically take them out, as well as preparing you to take down the sharks too.

The last point is a good one – I can’t reiterate enough through removing surprises and fear, this whole “money” thing becomes a lot easier and makes for much better sleep at night.

How do we create our “Debt Snowball”?

Like I said, I love the snowball because it’s simple:

  • Grab all your bills/contracts and whatnot. Everything that means you have some kind of “credit agreement” with an organisation.
  • Write down any money you owe to friends/family.
  • Now list ALL of them on one piece of paper/spreadsheet (whatever your tool of choice is). Ordered from smallest to largest, clearly showing how much is owed, and the minimum payment required (where applicable).
  • Now add these items to your budget (the ones with minimum payments are already there though, RIGHT? ;). Even if some of them have “0” in.

This is our snowball. If you have a snowball like mine, you are probably looking at the bottom figure and sweating a bit. Don’t worry, that’s fine. It will be gone soon enough :)

So, I have a scary list/”snowball” – now what?

OK, so we now have three important things:

  1. We have a sight for our weapon (the budget).
  2. We have a mechanism for generating extra ammunition (through cutting).
  3. We have a hit list (our newly creating snowball).

So, let’s start taking these things out shall we?

  1. Every month when you create your budget, take every surplus £/$/whatever and pile them all on to item at the top of the list.
  2. Make the payment to the card/company or whatever ASAP (to stop accruing interest as quickly as possible). If this is not an option, then get it into the allocated savings to gain some interest and prep to take it out in one fell swoop. Remember, allocated savings are allocated – it’s not the “buy a new plasma TV fund”.
  3. Keep paying the surplus each month to the top item, or saving. Once you have cleared the debt cross it off the list. Go ahead, you can smile/dance/streak – it does feel great crossing it off :)
  4. Now, you should have some extra surplus (the minimum payment to the debt you just cleared) as well as the surplus created through cutting. Load ALL of this onto the next item.
  5. Rinse and repeat until the list is history.

A few points to note:

  • We are always paying minimum payments first. You make a commitment to these credit people, stick to it.
  • We are focusing our real effort (the cutting) and it’s product (the surplus) on one thing at a time.
  • Once we have killed one target, we then throw everything at the next.
  • You will be amazed how much velocity you can build up. Worried about when you start getting to the bottom of the list and those big scary numbers? Well, you are going to be throwing a LOT bigger punches by then. They don’t have a freaking chance.
  • We don’t start having fun with the surplus until the list is dead.
  • Responsibilities first, fun later.

The last two points are important – it’s easy when you start getting to the bottom of the list to think “oh wow I don’t need to put that much into that debt”. Well, guess what? You DO. YOU NEED TO PAY THE DEBT.

And the best bit:

Once the list is done, you are going to have a lot of steam built up to start putting in to fun things. And you should do so, you have earned it my friend.

Some Tweaks

The book prescribes the method as above – however, I did make a couple of relatively minor tweaks – these should only be done if you have the discipline to not mess around!

Interest Rates

I re-jiggled some of the smaller debts to clear based on rate of interest. Some credit cards have a crazy interest rate and it can cost a lot more if you keep them running for too long.

However, I would say only re-arrange debts that are within a few hundred £/$ of each other. You need to keep the really big fish towards the bottom of the list because the motivational power of killing all the small fish first can really give you a boost in cutting more (not to mention it’s one less debt to worry about).

Loans and Early-Exit Penalties

Some (read: “most”) loan agreements have an early-exit penalty. If you want to clear the account early, then they will charge you an additional rate based on the term remaining. Make sure you read the loan agreement carefully (it should be in a clearly-marked section) or you can get a nasty surprise when the account suddenly has additional debt piled into it after you make what you believe to be your final payment.

In situations like these, put the cash into your allocated savings and draw from it each month when a payment goes out. This enables you to get a little bit of interest on the cash, as well as remove the debt. Just keep it allocated and don’t touch it.

In Summary

A simple, yet effective tool for tackling the debt owed. I love the way it focuses us on building our velocity up to run through each and every account. Believe me, it feels really good crossing off those big fish at the bottom :)

Happy debt-slaying :)

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