Note: This is the third post in our budgeting series. If you haven’t read the first two, check out Budgeting 101: The Foundation of Financial Freedom and Tips for Sticking to Your Budget.
Have you heard of the Stanford Marshmallow Experiment? It was a psychological experiment conducted by a Stanford professor in 1972. In a nutshell, the professor brought kids in and left them in a room with a marshmallow and a choice: eat the one marshmallow or wait fifteen minutes and get two marshmallows. The test was designed to measure the kids’ ability to delay gratification and see how that impacted future success. A lot of the kids couldn’t wait the fifteen minutes and ate the marshmallow. Delaying gratification is hard for kids and adults both. Often though, it’s worth it.
In this post, we’re talking about the long game; being patient and strategic with money now for results that will pay off in the future and we could be talking years in the future. To do that, you’ll have to delay gratification by saying no to the marshmallow, fancy new tv, or whatever shiny extra you’d really like to have now in favor of saying yes to extra payments against your debt.
Back to the Budget
You’ve already made your budget and you’ve been working hard to stick to it. You need to revisit the budget and find yourself some extra money to put towards debt every month. And, realistically, there isn’t any “extra” money in there. You probably need to cut your budget in one area to free up that money to go toward debt.
How much do you need? As much as you can make work, but as little as $50 will make an impact, and as you pay down debts, the amount you have to work with will grow. The more you can dedicate to debt, the faster you’ll see results, but every extra dollar you put toward this is saving you money. How is paying money saving money? Interest. The faster you pay off debts, the less time and principal there are to accumulate interest, the fee you pay to borrow money.
Choose Your Approach
Two of the most popular (and simplest) methods for paying off debt are the “snowball” and “avalanche” methods. Both work, and one isn’t, strictly speaking, better than the other. It all comes down to what motivates you. One gives you small wins faster, the other will save you more on interest but can take longer to feel like you’re making progress.
For either approach, you need a list of all your “bad” debts. Bad debt in this context just means debt that isn’t doing you any favors. Your mortgage is considered good debt because it’s tied to an asset—your house—same with your car loan. This list should be unsecured debt like credit cards, personal loans, student loans, medical debt, etc.
You’ll want your list to include the current the principal of each loan and the interest rate. Next, you select one of the loans from your list; take the amount you newly budgeted to go toward debt, and add that to your regular monthly payment every single month. It helps to set up an automatic payment for the new amount so you aren’t tempted to go back to paying the minimum.
How do you know which loan to pick?
In the snowball method, you start with the loan that has the smallest principal amount. This approach gives you quick wins. Because you’re putting the extra payments toward the smallest loan, you’ll have that loan paid off pretty quickly. If you started with your biggest loan, it would take much longer to get it paid off.
Let’s say that small loan is a student loan with a minimum monthly payment of $50. You’re putting $100 extra toward it every month for a total monthly payment of $150. When it’s paid off, you have $150 in your budget that no longer needs to go toward that loan. So you take that $150 and start paying it on top of the minimum monthly payment of your next smallest loan. You start with a snowball that grows bigger and bigger as you pay off more loans.
The avalanche has the same basic premise—pay off one loan faster by paying more than the minimum payment until it’s paid off, then apply the amount you were paying to the next loan. The difference is just the order that you pick the loans in. Instead of starting with the smallest loan, you start with the loan with the highest interest rate. Most likely, that’s going to be a larger loan because larger loans often have longer terms with corresponding higher rates. It might not play out exactly that way (credit cards for example tend to have high rates, but the balance could be small or large), but that’s the tendency.
That means it can take longer to see the little victory of having the first loan paid off. The reason you would pick this method is that by paying off the loans with the highest interest first, you’re saving more on interest overall. It’s called the avalanche because it starts slow but picks up speed and the last few loans are wiped out very quickly by the time you get to the end of the list.
Again, both methods work. You should pick the one that you think will motivate you more. As you pay off loans and grow your snowball or avalanche, take the whole amount you were paying and apply it over and above the minimum payment of the next loan on the list. Stick with it and it will work. Setting up automatic payments is extremely helpful.
Look for Shortcuts
Slow and steady wins the race, but that doesn’t mean you can’t take a shortcut if it’s there. When you have your list of loans assembled, look for shortcuts. In this analogy, a shortcut is refinancing. We’re in an exceptionally low rate environment right now. Look at the loans in your list and shop around for better rates. Watch out for loan application fees or balance transfer fees that could eat up savings, but if you can get a better rate, those extra payments will have an even bigger impact. Take a look at GOLD’s loan rates; I bet you’ll see some savings if you have loans elsewhere.