Your Money_ The Missing Manual - J. D. Roth [32]
Destroying low-balance debt first
If you've tried following the highest-interest-rate-first advice and still struggle with debt, there's another way. In his book, The Total Money Makeover, Dave Ramsey advocates an approach to the debt snowball that tackles accounts with low balances first. (Ramsey didn't invent this method, but he's popularized it over the past decade.)
With this version of the debt snowball, you ignore interest rates when determining the order in which you'll pay off your debts. All you look at is how much you owe, organizing the debts from smallest balance to largest balance.
Our friend Karen Kashout, for example, would arrange her debts like this:
$2,000 computer loan at 10%
$3,000 car loan at 4%
$8,000 credit card balance at 12%
$20,000 college loan at 5%
After she lists her debts from smallest to largest, she'd make the minimum payment on all of them except the smallest: the computer loan. She'd throw every dollar she can at the computer loan until it's gone, and then move on to her next smallest debt, the car loan.
This method may not be as quick as paying your high-interest debt first, but it provides tremendous psychological reinforcement. You get some quick wins—checking creditors off your list—that encourage you to keep at it. Dave Ramsey calls this "behavior modification over math," and he's right: The most important thing when paying off your debts is to, well, pay off your debts; the order in which you do so is irrelevant.
Critics of this approach argue that the math doesn't make sense, and they're right: If you use this method, you will pay more interest than if you had the discipline to pay off your debts based on interest rate. But humans are complex psychological creatures, not adding machines. We usually know what we ought to do, but that doesn't mean we always do it. If we were adding machines and always made the best choices, we wouldn't get into debt in the first place!
Other approaches
You can use the debt snowball to get out of debt in other ways. For instance, you might decide to first target the debts that give you the biggest headaches. Do you have a loan from your sister and her husband? Do you hate the fact that you borrowed money to buy a new computer? Whichever debt bugs you most, pay it off first.
Tip
To learn more about the debt snowball and the various ways to use it, download this free spreadsheet from Vertex 42: http://tinyurl.com/v42-debt. (You can see a video demo of the spreadsheet at http://tinyurl.com/v42-video.)
Regardless of which order you use to destroy your debt, put as much money as possible toward this goal. Apply raises and windfalls (like tax refunds) directly to your bills. Sure, you'd rather spend that birthday check from grandma on a night out with your friends, but it'll do you more good if you use it to pay off that last night on the town. You'll have plenty of time to spend future windfalls; for now, use the money to get debt off your back.
And if someone tells you that you you're being stupid if you don't follow a debt-repayment plan that minimizes interest payments, just ignore him. The ultimate goal is to get your debts paid off. Know yourself and choose whichever method makes the most sense for you and your financial situation.
Tip
For the lowdown on the pros and cons of using home-equity loans to pay off credit card debt, head to this book's Missing CD page at www.missingmanuals.com.
Other Tips and Tricks
You can do lots of other things to improve your situation while you're working on the three main steps of debt elimination. But all the debt-reduction tips you'll find are based on one simple fact: To