Ask any financial adviser or better yet, ask any millionaire and they will all tell you the same thing, the number one wealth killer is debt!
Now not all debt is bad. There is good debt and there is bad debt. Good debt helps you acquire assets that will increase your wealth like a mortgage. Bad debt on the other hand only increases your liabilities and only leads to the destruction of wealth. Bad debt includes consumer debt and credit card debt.
If you ask people if they would like a 20% annual return on their money – most would bite your hand off! But this is exactly what you would get if you were to reduce your consumer debt. Many Credit Cards and Finance options have a 20% interest rate fee per annum. That is ridiculously high. And just like how returns are compounded, the fee you pay for your debt is compounded annually as well. You see, over the long-term you will pay thousands and thousands of pounds just on the interest payments and this money could have easily gone to an investment account. By taking on bad debt, you are essentially destroying your wealth creating ability.
So the first thing you need to do is get out of debt. This is easier said then done but there is some techniques which actually work. One of the best methods of reducing debt is by using the snowball effect.
Debt snowball Effect
In essence, the debt snowball effect is a method on how to pay off debt when you have multiple accounts in debt. The strategy is that you should begin paying off accounts that have the smallest balances first whilst only making minimal payments on the larger debts. Once the smallest debt is paid off, you should go on to pay off the next smallest debt. You should carry on this technique until all your debt is paid off.
Here is how it works!
The following is an excerpt from “http://www.daveramsey.com/blog/how-the-debt-snowball-method-works.”
Pay minimum payments on all of the debts except the smallest one then attack that debt with a vengeance. Use all your focus and energy to wipe out that debt. Once it’s gone, take the money you were putting toward that debt, plus any extra money you find, and attack the next debt on the list. Once it’s gone, take that combined payment and go to the next debt. Knock them out one by one.
Here’s an example. Let’s say you have the following debts:
- £300 medical bill (£50 payment).
- £2,460 credit card debt (£60 payment).
- £5,500 car loan (£140 payment).
- £7,800student loan (£100 payment)
With the debt snowball, list the debts in that order (remember, ignore the interest rates). Start by making the minimum payments on everything but the medical bill. For this example, let’s say you find an extra £300 each month by taking an extra job, slashing your lifestyle to nothing, and going crazy. That’s very doable.
Since you are paying £350 a month on the medical bill (the £50 payment plus the £300 extra), that medical bill won’t even last a month. Now, take that £350 and attack the credit card debt. You’ll be paying £410 on the plastic (the freed-up £350 plus the £60 minimum payment). In about 6 months, wave bye-bye to the credit card debt. You’ve paid it off!
Now we’re at the car debt. Punch that car note in the face to the tune of £550 a month ( £410 + £140) . In 10 months, it will drive off into the sunset. Now you’re on fire!
Once you’ve gotten to the student loan, you will be putting £650 a month on it. It will only last about 12 months.
Thanks to your hard work and sacrifice, you have paid off just over £16,000 in debt in only 29 months using the debt snowball! Congratulations!
The point of the debt snowball is behavior modification. In our example, if you start paying on the student loan first because it’s the largest debt, you won’t see it leave for a while. You’ll see numbers going down on a page, but that’s it. Pretty soon, you’ll lose steam and stop paying extra, but you’ll still have all your debts hanging around.
But when you ditch the small debt first, you see progress. That one debt is out of your life forever. Soon the second debt will follow, then the next. When you see that the plan is working, you’ll stick to it. By sticking to it, you’ll eventually succeed in becoming debt-free!
By the time you are paying on the bigger debts, you have so much more cash freed up from paying off the earlier debts that it creates a “debt snowball” effect. You are putting hundreds of dollars a month on your bills instead of a few bucks here and there. You build momentum, which changes your behavior and helps you get out of debt and stay that way.