In a previous post, we reviewed Step One of Dave Ramsey’s seven-step guide for reducing debt and building wealth in his book, “The Total Money Makeover“. As we will be covering each of these “baby steps,” as Ramsey calls them, in individual postings, let’s look at the next one.
How The Snowball Method Works. Once you establish an emergency savings account (per baby step one in Dave Ramsey’s book), you are ready to come face-to-face with your debt situation by using the snowball method to pay off your debt. In my opinion, this is the hardest of all of the baby steps.
If you are not familiar with the snowball method, it is a financial method in which your debt is paid down by –
- Organizing debts from the lowest balance to the highest monthly expense;
- Allocating that specific amount be paid toward each debt monthly;
- Paying the minimum amount on all the debts, except the debt with the lowest balance;
- Putting the remainder of all your money left over from paying your bills (lights, mortgage, etc.) that you calculated in your budget towards the debt with the lowest balance; and
- Continuing the process after the first debt is paid, then moving all of that money towards paying off the next highest debt. So, now you are paying all your disposable income, plus the old payment, plus debt #2’s normal minimum payment, and then constantly repeating the process by piling old minimums onto
Bottom Line Up Front. Clear as mud, right? The debt snow ball is simple even though it is hard to quantify into words. You pay your smallest debt off with all your disposable income that you have left over from paying all your bills (based on your monthly budget). Then, you move on to the next one with ALL your money. And, then the next….and the next…and the next until it is all gone.
Why the Snowball Method is Better. The approach that Ramsey suggests is a good way to pay off debt, especially for anyone who does not follow a disciplined approach toward spending or saving. Contrary to Ramsey’s suggested method, most debt specialists will advise you pay down your debt with the highest interest rate, but Dave Ramsey does not recommend this based on emotion. There is a certain amount of satisfaction associated with paying off one of your debts whether it is a Visa card, HELOC, car payment, or some other debt. Ramsey’s debt snowball builds on that enthusiasm. You get fired up, and that keeps you going.
You can become quite frustrated with this method though if the debt with the highest amount of interest is somewhat substantial. By using Ramsey’s method, you can get rid of your debt faster so you can proceed on to the next steps of completing and funding your emergency savings account, investing for retirement, saving for your children’s college, paying off your house payment, and finally realizing the goal of building real wealth. With Ramsey’s book, The Total Money Makeover, you can learn how to get rid of the negative impact that debt can have on your life. Therefore, the snowball method is the best way to eliminate debt so you can learn to save.
A Review of the Basic Steps for Saving, Eliminating Debt, and Building Wealth
Ramsey’s program and book, “The Total Money Makeover“, include the following baby steps to financial freedom…
- Step One: Save $1,000 for an emergency fund
- Step Two: Use the debt snowball method to pay off your debt
- Step Three: Complete the emergency fund
- Step Four: Invest 15% for retirement
- Step Five: Save for your Children’s college
- Step Six: Pay off your mortgage
- Step Seven: Start building wealth
For the next seven days, I will be detailing each one of these baby steps in more details. So, please check back or sign up to get all of the posts in this series in your favorite RSS Reader or by E-Mail.
{ 3 comments }
I have a question regarding this step (perhaps I should buy the book instead of asking you a question, but I figured it wouldn’t hurt to ask!)
My wife and I both work and live overseas and are making a decent living (we live off of >1 income and save the rest)
We are currently paying off the following debts:
CC – $1200
Car loan – 3500
Student loan $15500 @ 3.56%
We are currently paying $250 a month towards the cc bill (and no longer use a cc unless we can pay the bill in full at the end of the month)
$350 a month towards the car loan (will increase to $600 once the cc is paid off)
and $200 towards the student loan (min payment is $150 a month)
We have $2000 in an immediate emergency funds and are on track to contribute $10000 to our retirement ($5000 in each IRA) by December (we don’t have a 401k since we work overseas – our companies give us %10 of our salary for retirement purposes) Additionally we have $30,000 invested in mutual funds and cd’s with $6000 of that in a money market account and have that money earmarked for a down payment on a house that we would like to buy when we move back to the US in 3 – 4 years (would like to put 30% down as I have a marked credit report from past mistakes as does my wife).
We routinely contribute $4000 a month (save 2 to 3 times a year when we pay tuition for our masters degrees courses) to the house fund.
Question is; I can see the advantage in paying off the cc and car loan asap with the cash that we place into our house fund, but what about the student loan? With a 3.56% interest rate and $15,500 principle, should we concentrate on paying off that loan before saving for a house? Or is it more worthwhile to continue to pay off that loan each month (snowballing the amount paid once we pay off the cc and car loan) and continue to contribute to a 3 – 6 month emergency fund and then the house fund?
Just found your site and I dig reading it!
Thanks in advance for any advice!
@ Brian –
If you read Dave Ramsey’s book, listen to him on the radio, and follow his advice, then he will tell you that you should stop contributing to investments, home savings, etc. until you have ALL your debts except a mortgage paid off. Even with your low interest rate, his program tells everyone to pay off all loans using the debt snowball and then beef up emergency savings to 3-6 months of expense, save for college, save for a new car, invest 15% of your income for retirement. So, to answer your question, yes…. I would concentrate on paying off the student loan before saving for a house.
One question I had for you though…. Why are you paying more towards your student loans at a great interest rate rather than putting that extra $50 per month into driving down your credit card debt?
Hank-
Thanks for the comments.
Decided last night to pay off the cc bill come the end of the month. Then we’ll pay off half the car loan in June and the other half in August (I don’t get paid in July). Then we’ll start throwing tons of cash at that student loan.
The reason I was questioning paying off the student loan was due to its low %.
I’ll be picking up his book when we get home next month. Unfortunately we can’t pick up his radio show over here in China!
Thanks again for the suggestions and I look forward to the posts to come!
Brian-
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