The way to accelerate multiple debt repayments (and make you feel you are finally getting somewhere!).
For clients in problem debt, I first request a recent Standard Financial Statement (SFS), a document which is the bane of the lives of those in mortgage debt. They are documents which are recurrently requested by the lender and give a snapshot of income, expenses, debt and assets of a household. They are painful to complete, painful! What they do illustrate on completion is that all creditors cannot be kept happy with limited resources. Many just scatter payments into creditors according to who shouts the loudest.
Frequently, addressing unsecured and smaller debt repayments with a strategy is all that is needed to free up capacity in the long term, either for a mortgage or other expenses. More importantly, there is a distinct psychological uplift in seeing debts being paid off, and knowing the exact timeline on this.
There are two distinct strategies that can add a systematic approach to clearing a list of different debts with different interest rates: debt snowballing by balance and debt snowballing by interest. Steps 1 to 3 below should be completed in advance.
Always gather and know your debt information. I am amazed by the number of clients who do not know the term, interest rate or balance outstanding on their smaller debts. It is the interaction between these variables that determine how much you will pay, monthly and in total. This information is available to you from your creditors. Set aside an hour to get this done.
Try to free up a few extra quid to divert to your debts. There are many ways to do this: getting an extension of your repayment term, switching provider, paying down a lump sum for full and final debt settlement and reducing other spending are examples. This may allow you free up money which you can use to kickstart your strategy below.
Determine which one of the two strategies to use. Each have both psychological and practical pros and cons. It is important not to add to the creditor list while the chosen strategy is in operation. The two strategies are:
- Debt Snowballing by Balance*
- Debt Snowballing by Interest
*Some use different terminology like stacking or avalanching but the concept is the same.
- Debt Snowballing by Balance
The idea here is to put every spare bit of money towards the debt with the lowest balance, forgetting all other variables. Say your list of debts looks like this and you free up an extra €100 per month by reducing spending.
|Creditor||Amount Owed||Term||APR||Payments Monthly|
|Credit Card||€5,000||6 Y 5M||18%||€110 (Min)|
|Bank Loan||€11,000||4 Y||9%||€275|
|Credit Union loan||€17,000||6 Y||7%||€290|
As soon as you pay off the Bank Overdraft with the extra €100 freed up on top of the €35 being paid already, you can now snowball or avalanche this €135 down to the next creditor, which means you are now paying €245 (€110 + €135) towards the Credit Card instead of €110 and so on. Once the credit card is paid off, the monthly payment for the Bank Loan will then become a massive €520 (€275 + €245), shaving years off the term and saving huge interest. The same subsequently applies to the Credit Union loan.
- Snowballing by Interest
The same principle applies to snowballing by interest, but any extra money is used to pay off the highest interest rate balance first. So pay the extra €100 available on top of the €110 payment towards the Credit Card first and, once cleared, switch that €210 to Overdraft, then move on to the Bank Loan and then the Credit Union Loan. Remember to keep all minimum payments going while doing this.
You can see the pros and cons of both strategies in terms of total interest paid and the argument for tackling higher interest debt first, but never underestimate the psychological boost associated with the visible clearing of debt and number of creditors. Regardless of the strategy chosen, having a PLAN that will show you an endpoint is incredibly important.
Play around with this method online with a snowball calculator. Input your variables (if you know them) and look at the result in report form. There are many calculators online but a useful one is www.whatsthecost.com/snowball.aspx. It is in Sterling but the principles are the same.