Monday, April 13, 2009

Got debt? Baby Step #2

Got debt? Join the club! Today I read an article about debt that had some statistics that were quite surprising. I thought I would share them:
  • Today’s consumer has an average of 13 debt obligations on their credit report.
  • The total amount of debt owed by Americans is more than 2.5 trillion. $8,500 per person on average.
  • 38% of the 2.5 trillion comes from credit card debt.
  • The average amount of credit card debt per card holder is $12,500 according to the Federal Reserve.
  • 74.9% of families had credit cards and 58% of those carry a balance.
Hopefully you do not fit into the categories listed above. But, if you are a "normal" American, you just might. So, what to do? Yesterday's post was on baby step #1, obtaining a beginner emergency fund of $1000. Once that is done, it is time to move on to baby step #2, getting out of debt.

Baby Step #2: Pay off your debts in order of smallest balance to largest. "Snowball" the payments as you go.

List all of your debts on a paper (or a spreadsheet if you prefer) arranged from smallest balance to largest balance. (Don't worry about interest rate unless you have two equal debts. In that case, list the largest interest rate first). Now, this is where the fun begins! This step is the hardest to complete, but probably the most satisfying. I can't even tell you the joy and peace I felt when each debt we had was finally paid in full! Most people can be completely debt free (except for their home) in 18-24 months. Yes, completely.

Start focusing on the first debt with the smallest balance. Every extra penny you can find goes to pay that balance down quickly. Do everything you can (even get a second or part time job) to reduce the first debt. Keep paying the minimum on all other debts. Once that first debt is paid and gone, then "snowball" its monthly payment: Add it to the normal payment you're making on the next-smallest debt, and focus your efforts on that next debt. It is amazing what happens when you are totally focused on this step. When that one is paid off, take that monthly payment amount and apply it toward your next debt. Each time a debt is paid off, the amount you were paying on that debt now is added on to the next debt. Make sense? Each debt that you eliminate makes the "snowball" get bigger and bigger, wiping out everything in its way.

"I’m convinced of the unstoppable potential of people when they get on fire for something."
— Dave Ramsey

You may wonder why the debts are not listed by interest rate, with the highest ones being paid off first. Dave explains: "The reason we list the debts from smallest balance to largest is to have some quick wins. Sometimes behavior modification is more important than math. This is one of those times." I personally have to agree. As we paid off each debt, we were so excited and couldn't wait to see how quickly we could get the next one paid off. It's amazing how fired up you become when you see success. Somewhat like dieting.

Remember: If you're working on this second Baby Step and some emergency arises which forces you to spend any part of your emergency fund, then immediately stop this step and return to Baby Step #1. Stay there until you've refunded your Emergency Fund in full.

It is important not to start your debt elimination on this step. If baby step #1 is not in place before starting baby step #2, this and all steps can be in serious jeopardy. We had to dip into our beginner emergency fund several times. Thankfully we had it! We were able to get through the "emergencies" without incurring additional debt, repay it, and get back on track with baby step #2. Just think how good you will feel, when those nagging debts are gone. BYE BYE.

You can find many debt snowball spreadsheets for free online. It is very motivating to see just how quick your debt can (and will!) be gone. Keep up the good work.

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