A few posts ago I talked about 1,000 Ways To Make Murphy Scream. This is basically Baby Step 1 as Dave Ramsey defines them in his book, The Total Money Makeover. Baby Step 1 is to save $1,000 as quickly as you can to form your beginning emergency fund. Having an emergency fund is a critical part of the process of getting out of debt. This might seem counter intuitive. I thought we were trying to pay down debt, why is the first step to save $1,000? Well, very simply you can’t get out of debt by continuing to borrow money. But what happens many times is people get excited about getting out of debt and for a couple of months maybe they seem to make some progress, but then Murphy shows up at the door. Your car breaks down. You have an unexpected trip to the doctor. The plumbing breaks. Whatever the case may be and the first thing you do is reach for the plastic because you have no money to cover this emergency. And then the discouragement sets in. What’s the use. Can’t get ahead. Might as well just accept the fact I’ll always have debt. And you give up.
One of the critical success factors in getting out of debt is breaking that cycle of falling back on debt any time emergencies hit. This is why Baby Step 1 is the starter Emergency Fund.
OK. So you have the $1,000 saved. Now what?
Baby step 2 is something Dave calls the Debt Snowball. Basically, the debt snowball is pretty simple.
First, list all of your debts except for your mortgage. We’ll worry about paying off the house later. If you have a home equity line of credit or other second mortgage and the total balance due on it is less than half your annual income then you should include it in your debt snowball. Additionally, you want to list all other debts you have. Credit cards, auto loans, medical bills, student loans, personal loans or loans from family members, pay-day loans, and any other debts you may have.
Now that you have your list of debts, you want to re-list them in order from the smallest balance to the largest. Now you want to make minimum payments on all of those debts except the smallest. You want to squeeze every nickel you can out of your budget. Maybe sell some stuff. Take any extra money that comes in. Get a second part-time job. Anywhere you can find some extra money. It’s ok to go a little crazy at this point. Throw it all at that smallest debt until it is paid off.
Now this is where the snowball part comes in. Once you have paid off that smallest debt, you’ll want to take everything you were paying on it plus the minimum payment you were making on the second smallest debt and throw all of that at that second smallest debt. Continue that until it is paid off and then move on to the third smallest debt. Each time you pay off another debt the amount you are putting on the next debt gets even larger, just like when you are making a snowball each time it rolls over it gets even larger.
So for example let’s suppose we had the following debts:
|Debt||Balance Due||Minimum Payment|
Let’s say after you have squeezed your budget for all you can get out of it you have an extra $200 each month to put on your debt. The first month you pay $220 on your Sears card plus the minimum payments on all the others. Now month 2 your balance on the Sears Card is only $180. So you take that $220 and pay off the Sears Card and put the extra $40 on the Visa. Month 3 the Sears Card is now gone So you take the $220 you were paying on it. Add it to the $30 minimum payment you were making on the Visa and you are now making a $250 a month payment on the VISA. At that rate in about 4 more months you’ll have that paid off. At that point you add the $250 to the $350 you are paying on the car and you start chunking $600 a month at the car. When it is done you can now put all your extra money on the Student loan, so you’ll be paying $800 a month on that. In the process you take any extra money you can get along the way by having a garage sale, selling some stuff on e-bay, maybe you get a bonus at work, or maybe you get the opportunity to work some overtime. Anyway you can get some extra money, you take all of it and go after the debt with as much intensity as you can manage. This is the debt snowball.
Now I can hear the math aficionados out there saying “hold on just a minute. Shouldn’t we be paying off the lowest interest rate debt first?” Stay tuned I’ll address that in my next post. While you are technically correct, I think Dave has some very good reasons for paying off the smallest debt first.
This method really does work. It isn’t magic. It isn’t easy. But if you stick with the plan and are mad enough at your debt to attack it with a vengeance, you will eventually be debt free. The average person who goes through Dave Ramsey’s Financial Peace University and follows the program is able to pay off all of their debts except their house in about 18-24 months. Depending on the amount of debt you have, your income, and your willingness to sacrifice, it might take you longer or you might be able to do it quicker. If you follow the plan though I guarantee you will get there. Sending in that last payment is an awesome feeling. Just imagine what it would feel like to wake up and know that you have no debts except your house payment. It makes all the sweat and sacrifice along the way worth it. We did it. You can do it too. If you start down this path post a comment or send me a message. I’d love to hear how you are doing and help by answering any questions I can.