A Time to Save – Part 3
I decided to give an in depth example of Priority 4: Large Debts
(Reminder we’re using the scenario of someone living with relatives, who currently has low living expenses and is trying to make more responsible choices with the remainder in their budget.)
If you have multiple large debts, there are two different methods for deciding where the extra should go first. In cold numbers, it’s best to first attack the debt with the highest interest rate. However, unless there a dramatic difference in interest rates, it’s probably wise to use the debt snowball formula (with credit to Dave Ramsey) to pay off your smallest debt first and then use that freed up cash to attack the next largest debt and so on.
The biggest advantage to the debt snowball is it helps reduce the number of debts you are dealing with, so if you do hit a future rough patch you’re dealing with 1 bill instead of 5... this also means more flexibility.
Let say your current debts have you paying per month $30, $50, $85, $150, and $250, and the debts they represent are $300, $400, $1200, $5000, and $30,000. It’s going to take years to deal with all of them. However, you can knock out the small ones more quickly.
(You won’t have $700 left from a $1000 monthly income, because you’re making $565/mo in debt payments, contributing $200, and still need $100 for spending. Number below are simplified but get the idea across.)
With the $135 you have left, you can take out debt 1 in 2 months ($300-2x$30-2x$135=-30) with $30 leftover to throw at debt 2.
Since you are no longer making that $30 payment, you now have $165 extra to attack debt. In another two months you’ve eliminated debt 2 ($400-4x$50-$30-2x$165=-160) with $160 left to throw at debt 3, freeing up a total of $205 per month.
Debt 3 is gone in month 7 ($1200-7x$85-$160-3x$205=$-170).
With your freed up income now at $290 per month, debt 4 will still take another 9 months to pay off ($5000-16x$150-$170-9x$290= -180) in full unless you work some over time or take a 2nd job.
But if you stick to it and get it done, you’ll have freed up $355 in your regular budget. This means you can more than double the payment and half the time on your long-term debt. It also means if you have a bad month or your expenses suddenly go up, you are in a much better place to handle the change.
When you started with $135 extra in your budget, a new $200/mo expense would have put you under, but now you could handle a new $200/mo expense and still have $155 extra to throw at your long-term debt.
However, if you had thrown all that $135 extra at your highest debt, you would still be paying on the three highest debts a year later, and need almost 3 years to pay down the second highest debt. That’s 18 extra months of having $150 tied up in a monthly payment.
That was quite a detour, but let’s say you stick to it. All debts are gone now. You’re living with your parents, contributing $200/mo, and keeping spending down to $100/mo. Emergency fund is full... Now what? Where should that $700 go? Is it party time?
Let’s explore that in Part 4.
(Reminder we’re using the scenario of someone living with relatives, who currently has low living expenses and is trying to make more responsible choices with the remainder in their budget.)
If you have multiple large debts, there are two different methods for deciding where the extra should go first. In cold numbers, it’s best to first attack the debt with the highest interest rate. However, unless there a dramatic difference in interest rates, it’s probably wise to use the debt snowball formula (with credit to Dave Ramsey) to pay off your smallest debt first and then use that freed up cash to attack the next largest debt and so on.
The biggest advantage to the debt snowball is it helps reduce the number of debts you are dealing with, so if you do hit a future rough patch you’re dealing with 1 bill instead of 5... this also means more flexibility.
Let say your current debts have you paying per month $30, $50, $85, $150, and $250, and the debts they represent are $300, $400, $1200, $5000, and $30,000. It’s going to take years to deal with all of them. However, you can knock out the small ones more quickly.
(You won’t have $700 left from a $1000 monthly income, because you’re making $565/mo in debt payments, contributing $200, and still need $100 for spending. Number below are simplified but get the idea across.)
With the $135 you have left, you can take out debt 1 in 2 months ($300-2x$30-2x$135=-30) with $30 leftover to throw at debt 2.
Since you are no longer making that $30 payment, you now have $165 extra to attack debt. In another two months you’ve eliminated debt 2 ($400-4x$50-$30-2x$165=-160) with $160 left to throw at debt 3, freeing up a total of $205 per month.
Debt 3 is gone in month 7 ($1200-7x$85-$160-3x$205=$-170).
With your freed up income now at $290 per month, debt 4 will still take another 9 months to pay off ($5000-16x$150-$170-9x$290= -180) in full unless you work some over time or take a 2nd job.
But if you stick to it and get it done, you’ll have freed up $355 in your regular budget. This means you can more than double the payment and half the time on your long-term debt. It also means if you have a bad month or your expenses suddenly go up, you are in a much better place to handle the change.
When you started with $135 extra in your budget, a new $200/mo expense would have put you under, but now you could handle a new $200/mo expense and still have $155 extra to throw at your long-term debt.
However, if you had thrown all that $135 extra at your highest debt, you would still be paying on the three highest debts a year later, and need almost 3 years to pay down the second highest debt. That’s 18 extra months of having $150 tied up in a monthly payment.
That was quite a detour, but let’s say you stick to it. All debts are gone now. You’re living with your parents, contributing $200/mo, and keeping spending down to $100/mo. Emergency fund is full... Now what? Where should that $700 go? Is it party time?
Let’s explore that in Part 4.
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