Tuesday, March 15, 2011

Money Management Part Five - Make a Plan to Reduce Debt

For the next four days, we are coming back to the financial world of Jack and Jill.  We'll go along with them as they become the masters of their money, eliminate debt and get securely on the path to financial freedom.

"Now," Richard looked serious.  "We need to get you on track to tackle your debts.   Have you ever heard of a 'debt snowball'?"

"A what?" Jack shook his head.

"This is something that will change the way you look at money.  Forever."  Jane pulled out a sheet with figures on it.  "I did some math for you so that you can see what we're talking about."

Jack took the page and he and Jill looked it over.  "Okay, what are we looking at?"

Jane and Richard pulled their chairs closer. "Let's go through this," he said.  "At the top we have your debts listed."

Account Balance Interest Rate Payment
Line of Credit              9,000.00 9.00%         270.00
MasterCard              2,400.00 18.00%           72.00
Visa              3,000.00 19.00%           90.00
Student Loan              9,000.00 7.00%         155.00
Car Loan            11,000.00 10.00%         280.00
Other              3,000.00 24.00%           90.00
Total Payment

"Next we have the payout schedule for all of these, assuming you continue making the payments you are making right now - that means keeping your payment the same, not reducing it according to the statement,"  Richard explained.

Account Balance Interest Paid Months Paid Off
Line of Credit              9,000.00              1,395.58 39 Jun-14
MasterCard              2,400.00                952.18 47 Feb-15
Visa              3,000.00              1,298.71 48 Mar-15
Student Loan              9,000.00              2,021.05 72 Mar-17
Car Loan            11,000.00              2,380.56 48 Mar-15
Other              3,000.00              1,993.24 56 Nov-15
Total Interest Paid:  10,041.32

"Yuck."  Jill grimaced.  "That's a lot of money spent on nothing... and we're going to be paying on these debts for another six years!!"

"Well, it could be worse, you know."  Jane pointed to the next table on the page.  "This is what would happen if you made only the minimum payments due as each statement came in."
 Balance  Interest Rate  Min Payment  # Months to Pay  Total Interest Paid 
Line of Credit  $        9,000.00 9% 3% 166  $    2,910.85
MasterCard  $        2,400.00 18% 3% 151  $    2,098.29
Visa  $        3,000.00 19% 3% 174  $    3,010.46
Student Loan  $        9,000.00 7%  $            155.00 72  $    2,020.85
Car Loan  $      11,000.00 10%  $            280.00 48  $    2,380.47
Other  $        3,000.00 24% 3% 234  $    5,332.23
 $  17,753.15

"Oh my gosh... that's... that's crazy!" Jill was stunned.  "So if we just keep making minimum payments, we're going to be paying on these debts for... how long is that?"

"Your last bill will be paid in nineteen and a half years... right about the time your oldest is graduating university."  Richard looked grim.  "The sad thing is, this is exactly what most people will do.  The minimum payment fits their budget, so they pay it.  They have adopted the mentality that 'if I can afford the payment, I can afford to buy it' - but you can see the results."

"Yeah.  Wow."  Jack looked a little overwhelmed by what he was seeing.  "But we can change that.  Just by continuing to make the payments we are making right now, we're saving ourselves over $7,000 and 13 years of payments.  I'm in for that!"

"Wait, though.  It gets better.  Check this out."  Jane pulled out a new page and laid it beside the first.  "Look what happens if we change things up a bit."   The new page had the words 'Debt Snowball' written across the top, and a new chart below.

Account Balance Interest Paid Months Paid Off
MasterCard              2,400.00                924.98 41 Aug-14
Visa              3,000.00              1,267.15 42 Sep-14
Other              3,000.00              1,859.96 44 Nov-14
Line of Credit              9,000.00              1,395.58 39 Jun-14
Student Loan              9,000.00              1,766.64 50 May-15
Car Loan            11,000.00              2,380.56 48 Mar-15
Total Interest Paid: 

"Nice!  How does this work?"  Jack was interested.  "This has shaved what, another 22 months off the payment schedule.  How?"

Richard grinned.  "This is the power of the snowball.  What happens here is this - you continue making your payments as you are right now.  Then, a few years from now when your line of credit is paid off, you take the $270.00 you were paying on it and you add that amount to the payment on the MasterCard.  That gets paid off in two months, then you take that total payment and apply it to the Visa for one month.  And you continue rolling the payments into the next debt until they are all cleared.  You can see how fast it all happens... it's like a snowball rolling downhill.  It starts out slow and small, but it gets bigger and faster as it approaches the bottom until it is a real force."

"I can see that.  Impressive!"  Jack had caught Richard's enthusiasm.  "Is there a way to make this even better?"

Richard laughed.  "I was waiting for you to ask that!  Let's take another look at this.  The basic idea of a debt snowball is that you start with the account with the lowest balance and pay them off in succession, ending with the biggest.  Now sometimes, like in your case, you'll actually end up with a bigger account paid off first, just because the payment on it is bigger.  And that's fine!  The idea behind paying the smallest bills first is just that it gives you the psychological boost of visible progress - those celebrations are great, but once you have the fever, you'll be hooked anyway!

"Now, if we want to make this even better, we need to be more aggressive.  The most obvious way to do that is to throw more money at the problem.  I don't want to tell you to cut your budget further right away, even though there is still plenty of wiggle room there.  It won't take long for you to get a handle on your spending and find more ways to save.  But that part is up to you.  The other way is to generate more income.  Any ideas?"

"Actually, yes!" Jill interjected.  "We were looking at me going to work..."   She noticed Jane shaking her head.  "No, no, don't worry - we figured out that it wasn't going to be worth it.  But what we did decide is that I will hang out my shingle again to take in a bit of bookkeeping work.  I can work from home in the evening or during the kids' quiet time, and put in a few hours on the weekend.  I've already had a few calls just by word-of-mouth, and it looks like we can count on my bringing in about $500 per month, working a number of ours that we're comfortable with."

(Missed the last series?  Check out "But I HAVE to work!!" to see why it wouldn't pay off for Jill to get a job.)

"That's great!  And did you know that by doing that, you'll be able to write off a portion of your home expenses?"  Richard asked.

"I had heard something about that, yes, but I don't know all the details.  Maybe we can have another meeting about that down the road a bit?"  Jill smiled hopefully.

"But of course!"  Richard picked up a cookie.  "Especially if you keep baking like this when we are coming over!"   They all laughed.  "All right then, let's look at the effect of this.  Let's say you bring in $500.00.  I'd like to see you take some of that and build an emergency fund, but first we need to tackle this debt more aggressively.  Especially that appliance loan."  Jill nodded.  "When do you start?"

"This week, actually."

"Excellent.  All right, here's what we need to do.  Some of this advice is a little unconventional, but we need to get rid of that loan before the end of November.  First off, I want you to take your entire $500 and pay it on this loan in August, September, October and November.  Then in November, before the due date on the loan, I want you to use your line of credit and pay this account off.  You'll have paid $1080 onto your line of credit by then, and you said there was a bit of room on it already, right?"


"Then this should work.  You will probably need to come up with a couple hundred extra by then to settle the whole balance - can you do that?  If there is even a few dollars left on this account on its due date, you'll be on the hook for about $1500 in interest."

"We can do it.  Thank you so much... we had no idea that loan would end up costing us so much!"  Jill was encouraged.  "What do we do next?"

"Well, once that one is out of the way, we continue with the snowball.  You take the $90.00 that you were paying on the furniture, and you apply it to the MasterCard.  Now you're paying $162.00 on that account.  It will be paid off next April.  When that is paid off you take that $162.00 and add it to the payment on the Visa - now you're paying $252.00 on that account, which will have it paid off in December.  Next, you take that $252.00 and add it to the payment on the line of credit, paying $522.00 until the following September when it will be paid off.  Then you roll that $522.00 over onto the Student Loan, paying $677.00 on it until the following April, when you take that payment and add it to your car, paying the car off the very next month.    Following this track, we'll have you out of debt in under four years, and saving literally thousands more in interest.

"Also, in December and January, you take your $500.00 from your business and you build yourselves an emergency fund in the bank.  You want to see it be at least $1000.00 set aside, so that when something happens you'll have the cash on hand to take care of it and you won't have to dip into your credit again.  Once that is in place, let's throw it all at your debt.  What do you suppose that would do for you?"

Jill could see that Jack was getting a taste for freedom.  "Do tell," she replied.

"Well, by adding $500 worth of snowflakes to that snowball each month, starting in February, we bring you down to just 31 months of payments, and you'll only be paying a couple thousand dollars in interest."

"Amazing.  So... after that... we'll have freed up $957 each month.  $1457 if Jill keeps working. That would make life a lot easier!!"  Jack enthused.

"Hold on, pal - we're not through with this yet!" Richard was jotting numbers on a page.  "What do you think you should do with that money?"

"Well, the car could stand to be replaced... there are things around the house that I'd like to finish up..."

Richard cut Jack off.  "Don't get ahead of yourself there, Jack.  We've got a few more things to work through yet before we get to that point."  

Jack looked confused. "But..."

"Do you really think $1,000 in the bank is enough?"

"Well... it's more than we have now... but I'm guessing the answer is no?"

"Definitely not.  Your next goal needs to be savings.  But for now, let's wrap things up and get you moving with your debt plan.  Deal?"  Richard stuck out his hand.

"Deal."  Jack shook his friend's hand.  "And thanks.  This is amazing.  Really.  I feel like a load of concrete has been lifted off my shoulders... not to mention feeling like someone just turned on the lights.  Man, it's crazy that we didn't see any of this before.  Most people don't, though, do they?"

"Sadly, no... that's why we've become rather passionate about this.  We want to see our friends get to where we are."  Jill smiled.  "And you guys are well on your way already!"

Get Out of Debt with the Debt Snowball Plan
The Truth About Debt Consolidation

Debt Reduction Calculator

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