Filed under: Banks, Cards, Debt

This repost is part of our series on strategies you can adopt to free yourself from burdensome debt.

Do you want to pay down debt, but aren’t sure how to do it? One of the ideal methods out there is called the snowball effect. This strategy of paying off debt focuses on getting rid of your highest interest rate credit cards first, which makes a lot of sense from a financial planning perspective because you reduce your interest expenses the fastest.

Think of the snowball effect as slowly building up the size of a your snowball then getting the snowball moving faster and faster by pushing it down hill. To use this strategy you begin by paying the minimum amount on all but your highest interest credit card. Then use each extra cent you can find to pay the greatest amount you can on your highest interest credit card.

When you get that card paid off, then continue paying the minimum amount you were paying on your second highest credit card plus the larger amount you were paying on the highest interest credit card.

Let me show you how this works. Suppose you’ve three credit cards that you’ve maxed out. Credit Card A charges 18% interest and has a balance of $1,000. Credit Card B charges 15% interest and has a balance of $2,000 with a minimum payment of $20. Credit Card C charges 12 percent and has a balance of $3,000 with a minimum payment of $35. In addition you have a car loan that charges 6% interest and a payment of $150 and a mortgage with a payment of $1,000.

I’ll assume this debtor has a total of $1,500 to pay bills to get the snowball started. To keep this easy I’m not going to compute interest, but that additional cost will slow down the payoff because balances will not go down as swiftly as shown here.

Month one you would use the $1,500 to pay:

Credit Card A $295

Credit Card B $ 20

Credit Card C $ 35

Vehicle Loan $150

Mortgage $1,000

After these payments the balances (not considering interest) would be:

Credit Card A $1,000 - 295 = $705

Credit Card B $2000 - 20 = $1980

Credit Card C $3,000 - 35 = $2,965

Month two you would make the same payments and the balances (not considering interest) would be:

Credit Card A $705 - 295 = $410

Credit Card B $1980- 20 = $1960

Credit Card C $2,965 - 35 = $2,930

Month three you would make the same payments and the balances (not considering interest) would be:

Credit Card A $410 - 295 = $115

Credit Card B $1960- 20 = $1940

Credit Card C $2,930 - 35 = $2,895

Month four you would pay off Credit Card A and any extra toward Credit Card B. Payments (not considering interest) would be:

Credit Card A $115 - Paid off

Credit Card B $200 (extra from Credit Card A after payoff - $180 plus $20)

Credit Card C $35

Vehicle Loan $150

Mortgage $1,000

Month four your balances (not considering interest) would be:

Credit Card A $0

Credit Card B $1960- 200 = $1740

Credit Card C $2,895 - 35 = $35

You can see that in four months you’d already have one credit card paid off. Starting with month five your snowball grows to $315 (the $295 that you used toward Credit Card A plus $20 (the minimum you were paying on Credit Card B)). In about six months Credit Card B would be paid off and then you could grow the snowball again to $350 toward Credit Card C ($315 you were using for Credit Card B plus $35 (the minimum you were paying on Credit Card B)). When Credit Card C is paid off than you can add the $350 to your $150 car payment and get rid of that more quickly. Finally you can use the extra $500 to pay down your mortgage more swiftly.

Of course, in order for this to work you must stop charging to your credit cards until you get them paid off. Once all your cards are paid off, if you want to use them and pay them in full each month that makes sense, especially if you’ve a good rewards programs.

After reading this post, one of my readers, Theresa Bolton-Lynch, contacted me about a money management tool that helps you pay down your debt even faster - including your mortgage. At first it sounded too good to be true. But, after take a closer look at it, I’ve named it the snow ball effect on steroids.

Lita Epstein has written more than 20 books including the “Complete Idiot’s Guide to Improving Your Credit Score.”

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Filed under: Cards, Debt

This repost is part of our series on strategies you can adopt to free yourself from burdensome debt.

Are you thinking about buying a home, but you need to improve your credit score in order to get the best interest rate? Paying down debt using the round robin strategy can get you there the fastest. People with the best credit score only use 10% to 20% of their available credit, so the faster you can pay down your debt on each card, the better your credit score will be. (If you’re looking to minimize your interest and a swift improvement in credit score doesn’t matter, then use the snowball effect strategy instead.)

With this strategy you first focus on paying down all your credit cards to a debt level of about 30% of your available credit. For example, if you have a credit line of $3,000, to be at 30% utilization the maximum balance you should have on that card is $900. When you get all your cards paid down to 30% utilization, then start working on getting them down to 20%. Once they’re all at 20% utilization then begin paying them down to 10%. Your final round robin stage will be to pay off the cards totally. When you reach the 10% goal your credit score should be up by at least 30 points and could be up by as much as 70 points. If you’ve had a history of late payments and are now paying your credit cards on time, your credit score could improve by as much as 40 points.

Will that make a large difference when applying for a mortgage? People with a credit score of 730 or higher get the best interest rate offers. As long as your credit score is above 730 there’s no reason to worry. Even if you push that score higher you won’t likely get a better offer. But if your credit score is below 675 you’ll pay nearly 2% more interest on a mortgage loan, which will mean thousands of dollars more in interest over the life of that loan. If your credit score is below 620, expect to pay 3% to 4% more interest on that mortgage loan. So taking the time to get your score up using the round robin strategy could make a massive difference in the loan packages you’ll be offered.

Here’s how you implement the round robin strategy. Suppose you have maxed out your cards. On Credit Card A you have a balance of $1,000 (minimum payment $10). On Credit Card B you’ve a balance of $2,000 (minimum payment $20) and on Credit Card C you have a balance of $3,000 (minimum payment $35). In addition you have a vehicle loan payment of $150 and a mortgage payment of $1,000. The total cash you have available to pay bills is $1,500. To keep things simple I’m not going to include interest calculations in this example, but interest will slow down your pay off.

Month 1 you would use the $1,500 to pay:

Credit Card A $295

Credit Card B $20

Credit Card C $35

Car Loan $150

Mortgage $1000

Remaining balances after Month 1 payments (not considering interest) would be:

Credit Card A $1,000 - $295 = $705

Card Card B $2,000 - $20 = $1,980

Card Card C $3,000 - $35 = $2,965

Month 2 you would make the same payments and remaining balances after Month 2 (not considering interest would be:

Credit Card A $705 - $295 = $410

Card Card B $1,980 - $20 = $1,960

Card Card C $2,965 - $35 = $2,930

Month 3 you only need to pay $110 to reach your 30% goal on Credit Card A, so the extra money can then begin working down Credit Card B. Your payments would be:

Credit Card A $110

Credit Card B $205

Credit Card C $35

Car Loan $150

Mortgage $1000

The remaining balances after Month 3 (not considering interest) would be:

Credit Card A $410 - $110 = $300

Card Card B $1,960 - $205 = $1,735

Card Card C $2,930 - $35 = $2,895

Month 4 you would pay all the extra cash you have toward Credit Card B, so you can start working that balance down to the goal of 30%. Your payments would be:

Credit Card A $10

Credit Card B $305

Credit Card C $35

Automobile Loan $150

Mortgage $1000

The remaining balances after Month 4 (not considering interest) would be:

Credit Card A $300 - $10 = $290

Card Card B $1,735 - $305 = $1,430

Card Card C $2,895 - $35 = $2,860

You would continuing making the same payments as you did in Month 4 until you get Credit Card B’s balance down to the 30% goal of $600 ($2,000 x .30), which should happen in Month 7. At that point you make just the minimum payments on Card Card B and begin paying down Credit Card C using the most you can. In about another five to six months you should reach the 30% goal on Credit Card C.

So in this scenario it would take a person about 13 months to reach the 30% goal. At that point, one should see a nice jump in credit score.Then you go back and start the round robin again paying down each card to 20% utilization to see an even more massive improvement in credit score. Ultimately you continue the round robin strategy until you get all your credit cards paid off and then use the extra cash to pay down the automobile loan. Once all other debt is gone you can begin working on paying down your mortgage faster.

Lita Epstein has written over 20 books including the Complete Idiot’s Guide to Improving Your Credit Score.

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