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Debt Snowball

What is the debt snowball?

Any ideas how to best deal with my debts, and ever heard of a debt snowball?  We have a large credit card debt with high interest rates and are making no headway to pay them off. Should I withdraw money from my retirement funds to pay off or pay down our credit cards? 

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Highlights

  • Review different strategies for paying down debt.
  • Compare debt snowball and debt avalanche.
  • Debt negotiation is a form of debt consolidation that reduces your total debt.

You have several options for retiring your credit card debt. Before I discuss those options, allow me to discuss your idea of raiding your retirement accounts.

401(k) Distribution

I have a strong bias against taking 401(k) or IRA funds, which you set aside for your retirement, to pay consumer debt. First, if you are less than 59½ years of age, you will pay a 10% penalty tax. Second, because IRAs and 401(k)s are pre-tax funds, you will pay income tax on the distributions. Third, retirement funds are exempt from bankruptcy and levy, so the funds are off-limits to creditors.

You mentioned paying-down your credit card balances and referred to a technique call the debt snowball.  I will explain debt snowball and compare it to debt avalanche, another strategy for paying down debt.

Debt Snowball

Consider the debt snowball approach to paying off your cards that will get you out of debt faster:

  1. Determine the maximum amount you can afford to pay toward your credit card balances.
  2. Look at your credit card statements and rank your cards in order, from the smallest overall balance to the largest.
  3. Every month, make only the minimum payments on all but the card with the smallest balance. Apply all the remaining money you can afford to the smallest balance card.
  4. Continue to do this every month until the smallest balance card is paid off — keeping the total amount you pay every month the same.
  5. Repeat steps 2-4 with the remaining cards, keeping your monthly payments constant until you are out of debt.

The combination of keeping your monthly payments constant even as your debt balances drop, while applying as much money as you can to the balance on the card with the smallest balance every month, can take years off the amount of time it takes you to get out of debt, especially if you have been only making your required minimum payments.

Debt Avalanche

Another approach is called “debt avalanche” or, occasionally, the “domino strategy.” Debt avalanche is quite similar to debt snowball, with one key difference. In debt avalanche, you target the debt with the highest interest rate, instead of the one with the smallest balance. Other than that, the strategies are implemented the same. You pay your required minimums to each creditor, taking anything you can afford and adding it to the highest interest debt. Once that debt is paid off, you target the next highest interest rate debt, until you have paid everything off.

Avalanche vs. Snowball

I recommend the debt avalanche strategy over the debt snowball for one key reason: it saves you the most money. There are financial experts who feel that the psychological boost you get from paying off a creditor, provides continued motivation to continue working your way out of debt. While not dismissing that there may be a positive benefit from paying off a creditor and eliminating a debt, I think there is a greater benefit from saving money; I value the financial benefit of money in my pocket over the psychological boost of crossing off one name from the list of people I owe.

I will illustrate the difference, by comparing the snowball and avalanche strategies, using real number as an illustration. Let's assume that Ms. Smith has $10,000 in credit card debt. He owes $5,500 to Citibank on a credit card with a 19.99% interest rate and owes Chase $4,500 on credit card with a 9.9% interest rate. The required monthly minimum payments for each card is $135, totaling $270 for the two cards. The next payments are due in March, 2011. One final assumption is that Mr. Smith can currently afford to pay $52o per month, in total, towards the two debts.

What is the best way for Ms. Smith to use his $520? Debt snowball targets the Chase account, as it is the account with the smallest balance. Avalanche attacks the Citi account, because it has the higher interest rate. Here are the numbers:

  • Debt snowball takes a total of $11,805.84 to pay off both debts' interest and principal. Ms. Smith will be out of debt in February, 2013 by using snowball.
  • Debt Avalanche takes a total of $11,412.80 to pay off both debts' interest and principal. Ms. Smith will be out of debt in January, 2013 by using avalanche.

To me, this choice is crystal clear. I would rather have the extra $397 that avalanche puts in my pocket, to use as I choose, rather than the psychological boost that snowball gives me from paying off my first account in April, 2012, as opposed to paying off the first account in August, 2012 via avalanche.

Here are two charts that illustrate how much interest you will pay and when you will be debt free, if you use the two approaches:

Snowball Payment

Avalanche Payment

If you are not making headway in retiring your debt, using either the avalanche or snowball method, then you should consider a more drastic tactic.

There are a variety of debt resolution options, including credit counseling, debt negotiation/debt settlement, a debt consolidation loan, bankruptcy, and other debt resolution options. It is important to understand each option and then pick the solution that is right for you.

Credit Counseling

A Consumer Credit Counseling Service (CCCS), is one specific type of debt management plan. It is a very common form of debt consolidation. There are many companies offering credit counseling programs. In a CCCS program, you start off by undergoing a financial review with your counselor. If your debt problems are serious, the counselor may recommend a Debt Management Plan. In a Debt Management Plan, you make one payment to the CCCS firm and it then distributes payments to your participating creditors. CCCS firms negotiate lower interest rates with your creditors. By obtaining interest rate concessions from your lenders or creditors, more of your monthly payment goes to your principal balances, thereby speeding up the time it takes to become debt free. Because the Debt Management Plan's main benefit is lower interest rates, it less effective for someone whose interest rates are already low.

It is important to understand that in a credit counseling program, you are still repaying 100% of your debts, plus some interest. Often, in Consumer Credit Counseling program, the size of the payment is not significantly lower than your current monthly minimum payments you are sending to your creditors. This means that if you are having trouble making your current payment, a CCCS program may not be right for you. The program demands that you make a timely payment each month. If not, you could end dropping out of the program without having resolved the debt problem.

A high percentage of people who enroll in a CCCS program's Debt Management Plan drop out. On average, most credit counseling programs take around five years. Although most credit counseling programs do not impact a FICO score, being enrolled in a credit counseling debt management plan does show up on your credit report and affects your credit rating. Unfortunately, many lenders look at enrollment in CCCS program as akin to filing for Chapter 13 bankruptcy. In both cases you needed the assistance of an outside firm to re-organize your debts.

In your case, a CCCS program will almost certainly cut your interest rates, and may be a viable option if you can afford the monthly payment.

Debt Settlement

Debt settlement, also called debt negotiation, is a form of debt consolidation that reduces your total debt. Savings can be as much as 50% and debt settlement programs will significantly reduce your monthly payments. Debt settlement programs are geared for people who have a financial hardship that makes it so they either cannot pay their bills or are about to start falling behind. Debt settlement programs typically take three years to complete.

It is important to keep in mind, however, that during the life of your debt settlement program, you are not paying your creditors. This means that a debt settlement solution of debt consolidation will negatively impact your credit rating. Your credit rating will not be good, at a minimum, for the term of your debt settlement program. However, debt settlement is usually the fastest and cheapest way to debt freedom, with a low monthly payment, while avoiding Chapter 7 bankruptcy. The trade-off here is a negative credit rating versus saving money.

Debt Consolidation Loan

Many people think first of a debt consolidation loan when seeking debt consolidation. It is really the only true consolidation, where the original debts are paid off by a lender who assumes the new debt. The most common forms of debt consolidation loans are home loan refinancing, taking out a second loan on a home (or a home equity line of credit) or, obtaining an unsecured loan. Since the credit crunch occurred, obtaining an unsecured loan at a reasonable interest rate has become difficult or impossible. In a debt consolidation loan, you exchange one loan for another. The most frequent form is taking out a mortgage loan, which carries a lower interest rate and is tax deductible, to pay off high-interest unsecured debt.

It is important to be aware that shifting unsecured debt to secured debt can create a volatile situation. If there is ever a chance that you cannot afford the new mortgage payment, you put yourself at risk of foreclosure! In the case of a debt consolidation loan, most mortgages are 30-year loan, which means that the total cost and the time to debt freedom could be very high, but the monthly payment will be lower than other options and there is no credit rating impact.

Bankruptcy

Bankruptcy may also solve your debt problems. A Chapter 7 bankruptcy is a traditional liquidation of assets and liabilities, and is usually considered a last resort. Bankruptcy is a public matter. You need to stand in public and declare that you are unable to pay your debts. Notices are published and your credit report will show that you filed for bankruptcy for at least seven years. Since the most recent federal bankruptcy reform went into effect in 2005, it is much harder to qualify for Chapter 7 bankruptcy.

It may be the case that a Chapter 13 bankruptcy will be the only one available. In a Chapter 13 bankruptcy, a person’s debts are reorganized. The debts are repaid, according to the terms established by the bankruptcy court. Chapter 13 bankruptcies usually run three to five years. If you are considering bankruptcy, I encourage you to consult with an experienced bankruptcy attorney in your state.

Default

You may be curious what may happen if you do nothing. If you stop paying your unsecured debts, creditors have the right to collect the debt. First, you will likely receive collection calls and letters from the creditor directly. If you are still unable to pay the debt after several months, the creditor is likely to refer the account to a third-party collection agency.

Third-party collectors are known to be much more aggressive in their collection tactics than original creditors, so do not be surprised if the calls become more persistent, or even threatening. Thankfully, the Fair Debt Collections Practices Act established rules that govern the behavior of collection agents. However, unscrupulous debt collection agents do not follow these rules. If you know your rights, you can protect yourself from improper creditor contact.

In some cases, when all other collection efforts fail, a creditor will decide to file a lawsuit against the debtor. This is not a frequent occurrence, but it is within a creditor’s rights and a possibility about which you should be aware. If one of your creditors sues you, the court will likely issue a judgment in the creditor’s favor. Depending on your state’s laws regarding the enforcement of judgments, the creditor may be able to garnish your wages, levy your bank accounts, place a lien on your property, or take other action to enforce its judgment.

Regarding a credit report, defaulting on a debt damages a credit score severely. In addition, default is a warning flag for many lenders, who will refuse to deal with a potential customer with a default on their record. As a result doing nothing and allowing default is a poor option for most consumers.

Summary

Although there are many forms of debt consolidation, many people with good to perfect credit who own homes should look into debt consolidation loans, while consumers with high unsecured debt and poor credit may want to explore debt settlement or debt negotiation. However, each consumer is different, so find the debt consolidation option that fits for you.

Lastly, here are four fast tips for your own quick debt consolidation evaluator:

  1. If you have perfect credit and have equity in your home, then consider a mortgage refinance.
  2. If you can afford a healthy monthly payment (about 3 percent of your total debt each month), your interest rates are a problem, and you want to protect yourself from collection and from going delinquent, then consider credit counseling.
  3. If you want the lowest monthly payment and want to get debt free for a low cost and short amount of time, and you are willing to deal with adverse credit impacts and collections, then evaluate debt settlement.
  4. If you cannot afford anything in a monthly payment (less than 1.5 percent of your total debt each month), then consider bankruptcy to see if Chapter 7 might be right for you.

Bills.com makes it easy for you to apply for traditional forms of debt relief.

Recommendation

I dislike liquidating your IRA or 401(k). Default is rarely a good option. CCCS may be a viable option if you can match your expenses to your income and can afford the payments. If you cannot afford the monthly CCCS payments, then debt settlement is a good option, and is preferable to bankruptcy from a credit score perspective.

I hope this information helps you Find. Learn & Save.

Best,

Bill

Bills.com