The bills are piling up in the corner of your desk, and it seems that every day the mail brings a new stack to deal with. Although the collection agencies haven’t started calling yet, you know that it is only a matter of time before they do. You want to get out of debt and get back on track, but the whole thing seems so overwhelming. Fortunately, it really doesn’t have to be. Just start small and go from there.
Most financial advice about debt will guide you toward paying off the debt with the highest interest rate first. This makes sense from a purely logical point of view, since larger interest debts cost you more money in the long run, however, human beings aren’t always motivated by logic. After all, it isn’t usually logical to go into debt in the first place, but so many of us find ourselves there anyway.
Researchers at the Kellogg School of Management at Northwestern University have analyzed some data that was collected from a debt settlement firm. The data seems to indicate that despite the traditional logical advice, when it comes to debt it makes more sense to start small. In fact those who started small were more successful at eventually paying down their overall debt.
What does starting small mean? Simple. You gather your debt and then aim for paying off the smallest balance first. As human creatures, we are motivated by rewards. Tackling a small balance seems to give us the motivation to keep going with debt repayment. We become excited and committed by the first success, leading to bigger successes. Crossing even just one debt on the list is tangible, and it feels good.
After that first balance is paid off, you should then tackle the next debt, whichever one is now the smallest. Add in whatever you have left over from the smaller debt as well, making the next debt easier to pay off. With each new account closed, with each new win, comes the reinforcement we need to keep going. The practice of starting with the smallest debt and then adding that payment to the next, working up to the largest debt is called “The Snowball Effect” a term made famous by financial guru Dave Ramsey.
Let us use the example of a family that has a $250 personal loan debt, a $1,000 credit card debt, a $5,500 credit card debt and a mortgage of $350,000. Each of these debts carry minimum payments, which the family should try to meet. To make things easy, we will round out the minimum payments to $25, $100, $550, and $3,500.
The family could potentially hold a yard sale and pay off the $250 loan outright. They would then take the minimum payment of $25 they normally make on that loan, and add it to the minimum payment of $100 on the $1,000 credit card debt. $100 plus $25. So, the family would be paying $125 each month on the $1,000 credit card debt, or an extra fourth of the normal payment.
Again, any additional money that comes their way through budgeting or extra income should be applied directly to the $1,000 balance until it is paid off. Once that happens, the family will have an extra $125 they can add to the minimum payment on the $5,500 credit card debt. This is $550 minimum payment plus $125 from the snowball to equal $675 toward the debt each month. Make sense?