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Managing Debt Recovery - Part 2 - The Debt Snowball

Part 2 of a three, (3), part series explaining how to put together and manage a debt recovery plan. This module discusses the best way to get yourself out of debt.

Debt settlement and debt consolidation are not the same.  Both can help with debt but only one will reduce the total amount you owe.  Both will impact your credit but to a different degree.  You can expect debt consolidation loans to impact your credit score negatively because a debt consolidation loan has traditionally been a special circumstance loan that will pay off specified debts.  It is still a personal loan from the bank but you cannot use it for whatever you want.  The bank will pay off your balances of other debt for you.  Debt settlement impacts your credit more harshly because you are paying only a portion of the debts owed to creditors.  With Debt Settlement, you agree with the creditor to pay, as an example, fifty percent of the total balance and on your credit report it will show "settled".  Niether of these methods are as damaging as declaring bankruptcy.  Basicly you have to make an appointment for bankruptcy.  In a bankruptcy you are declaring legally that you have no money for such frivilous expenditures such as trips to the movies, high end groceries, or credit card debt.  Okay, those are not all frivilous but the point is made.  A legal bankruptcy tells your creditors that you have no more money and cannot pay them back.  Interestingly enough, after a bankruptcy, it can be easier to get a credit card becuase you are not able to go bankrupt again for several years.  So, creditors know it is safe to lend you moeny again, albeit at a much higher rate than a borrower with a good repayment history.

The best choice, of course, is to take it upon yourself to flesh-out a debt management strategy primarily focused on controlling your spending and paying off your debts one at a time.  The idea is called the debt snowball method.  You make the minimum payments on all your debts but the debts with the really low balances get paid off first followed by the debts with the highest interest.  If you have 5 debts:
A. $2,500 balance at 18% and a minimum payment of $ 62.50 per month
B. $8,000 balance at 14% and a minimum payment of $120.00 per month
C. $  500 balance at  9% and a minimum payment of $ 10.00 per month
D. $   85 balance at 21% and a minimum payment of $ 10.00 per month
E. $  900 balance at 21% and a minimum payment of $ 18.00 per month

In the above senario your minimum monthly payments are $220.50 per month.  Let us assume for a moment that your discretionary spending, (money you can blow on movies and such), is $150 a month.  Now let us take that $100 and pay off some debt.  The first one you want to pay off is the $85 balance because that will give you an extra ten dollars to put towards your "debt snowball."  There will be a little left over to pay down the balance of another debt.  We will look at paying off a higher interest debt now and start to pay off debt "E".

Once debt "D" is paid off and a portion of debt "E", you are left with:
A. $2,500 balance at 18% and a minimum payment of $ 62.50 per month
B. $8,000 balance at 14% and a minimum payment of $120.00 per month
C. $  500 balance at  9% and a minimum payment of $ 10.00 per month
D. $    0 balance at 21% and a minimum payment of $     0 per month
E. $  835 balance at 21% and a minimum payment of $ 18.00 per month

The extra amount you have to pay off debt now goes up to $160 a month.  We continue to pay down debt "E" each month with the extra $160 until the balance is Zero.  For this example we have not calculated the minimum payments into the total owed, just noted that they continue to be paid.  In six months we will pay off the debt and start working on another debt.

A. $2,357 balance at 18% and a minimum payment of $ 62.50 per month
B. $8,000 balance at 14% and a minimum payment of $120.00 per month
C. $  500 balance at  9% and a minimum payment of $ 10.00 per month
D. $    0 balance at 21% and a minimum payment of $     0 per month
E. $    0 balance at 21% and a minimum payment of $ 18.00 per month

At this point we need to look at the benefit to paying off the small $500 debt or the higher interest $2500 debt.  Since the benefit is a ten dollar gain after a few months we are going to just begin to pay off the higher interest debt because it is double the interest of the $500 debt so let's bring it down to something reasonable.  After paying off debt "A" we our minimum payments are just $130 a month and the total addition we are able to put towards our debt is $240.50.  Now our snowball is much bigger and debt freedom is in sight.

A. $    0 balance at 18% and a minimum payment of $     0 per month
B. $7,802 balance at 14% and a minimum payment of $120.00 per month
C. $  500 balance at  9% and a minimum payment of $ 10.00 per month
D. $    0 balance at 21% and a minimum payment of $     0 per month
E. $    0 balance at 21% and a minimum payment of $     0 per month

There was still a little extra left over from the debt "A" payoff month so we have applied it debt "B".  Since we are paying an additional $240.50 towards debt "B", we will pay it off much quicker.  When you add the $240 extra plus the $120 minimum, we are able to pay off the debt in about 22 months.  Then we will pay off the $500 debt in just a couple months after that.

A. $    0 balance at 18% and a minimum payment of $     0 per month
B. $    0 balance at 14% and a minimum payment of $     0 per month
C. $    0 balance at  9% and a minimum payment of $     0 per month
D. $    0 balance at 21% and a minimum payment of $     0 per month
E. $    0 balance at 21% and a minimum payment of $     0 per month

Again, the calculations are not exact because every time you make the minimum payment the balance goes down.  So, we will pay off the debt sooner than that but the idea is the same.  Focus on paying off the debt that gives you the greatest long-term advantage to paying off your debt.  That is, in essence, the Debt Snowball Method.

In the next installment, we will discuss managing your credit durring your recovery.

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