Debt Snowball Principle

Imagine yourself playing in the snow on the side of a hill. You make a small ball the size of a tennis ball and roll it down the hill. By the time the ball gets to the bottom it should of grown bigger because it collects more layers of snow just like on Tom and Jerry.

Dave Ramsey made this term popular and so far it’s worked for me.

This principal can be applied to you personal finances too. By this I mean you start small, you take that extra 50 bucks and pay it into your credit card or store account that’s getting larger due to interest charges. How will the 50 bucks make a difference to an amount that looks like it will never come down?

Imagine you have 3 accounts that are various amounts and different interest rates.

1.       Susan’s Shoe Mecca – Outstanding balance: 1000 Interest rate 10% (minimum payment: 80)

2.       Mikes Hardware –        Outstanding balance: 2600 Interest rate 8%   (minimum payment: 60)

3.       Your credit card –        Outstanding balance: 4000 interest rate 13% (minimum payment: 110)

Looking at the list which would you pay off first?

Logic tells you that number 3 is the most expensive and that will need to be paid off first. That’s a wise move and probably the most correct one. But after 3 months of paying the min payment along with the extra 50, you become despondent because it looks like it will never end. You might even stop paying in the extra money all together.

My advice (This is what I have done personally) eliminate account 1 first. You will be able to pay it off quicker and stay motivated to pay down the rest of the accounts. Then tackle number 2 then number 3. So how does the snowball effect work for the above?

You still the minimum on all the accounts as per normal but you select an account you going to pay in extra. So for me it was account 1, I pay the minimum of (80) +50=130. I continue paying this amount until the account is paid up. Then for account 2, I pay the minimum (60) plus the extra 50 plus the minimum payment of 80 from account 1. So it will be (60) +130=190 that gets paid every month. Then when account 2 is settled and all that is left is account 3 you do the same, (110) +190=300.

By doing it this way you save extra charges on the interest because you pay more than the minimum. After each account is settled don’t make the mistake of spending that extra cash, all that this exercise is really costing you is the extra 50 each month. Pretend you still have to pay the minimum even after the account is closed, and sooner than you think you would have eliminated all 3 accounts.

I have put this into practice and eliminated 2 credit cards and 2 store accounts this way. It does take patience, time and perseverance. If you have done this before or have a different approach, please feel free to leave a comment below.

What is Personal Finance?

This may seem pretty obvious to most, but there are so many different situations and everyone has a different set of circumstances. Here is a basic overview.

• Income and expenses

Gross Income, net income what’s the difference between the two? Gross income is money earned before any taxable deductions are taken off. This is normally your package deal that you earn from your employer each month. It’s higher than your net income, and if we didn’t have to pay taxes we would all be better off earning higher salaries.

Earned income or net income is the amount you left with after all taxes and any company benefits are deducted, for example pension contributions or medical contributions. This is the amount you receive in your bank account.

Disposable income is what you have left after paying off your monthly contributions, for example pay off debt, groceries, utilities, auto financing etc. If you are in debt then usually this amount seems quite small, and also demotivates you in paying off your debt faster.

• How to manage Personal Finances

No one likes the word budget, nor do we want to live frugally forever saving each penny. But a budget can help you in managing your finances better.

Take a piece of paper, draw a line down the centre and list all your expenses and all your income you received after tax (Net income in your bank account).Subtract your expenses from your income and you left with disposable income. You can call this budgeting or if you don’t like the word call it your Income statement or expense statement. Get into the habit of doing this once a month to monitor your progress through the year.

This can help you allocating funds towards paying off debt and saving a portion of the surplus funds.

Personal finance shouldn’t be a daunting task to manage, there are plenty finance software packages out there. Some you pay for and others are free, visit mint.com this site is free and has a lot of information as well as finance calculators you can use.

So essentially think of your personal finances as corporations finances. You have an income and some expenses. For a profitable company to exist, you need to make sure your income exceeds your expenditure. Bank the profits and live a comfortable life with money in the bank and completely debt free.

Emergency Fund - Have You Got One?

Have you ever been caught off guard and been surprised by an unexpected cash emergency? I have, and it took me a while to realise that phrase “It will never happen to me” is so false.

What is an emergency fund? Basically money saved for that moment when something goes boom and you need to pay for a repair or replacement ASAP, or a family member is sick and you need to buy an airline ticket. These funds should be easily accessible and ready to use.

You don’t need to only have 1 emergency fund; I have 2 at the moment. One is for in case I lose my job and need to cover expenses; I am trying to save up at least 3 months’ worth of expenses in my salary fund. I have put this money into a call account that requires a month’s notice to release all or part of my funds. My reasons are:

1.       I don’t want to be tempted to dip into these funds unless absolutely necessary e.g. job loss

2.       I can setup a “pay day” payment that pays a portion out each month, like if I still received a salary.

3.       The interest earned is compounded monthly to help raise the balance.

I do however have another account that I use for immediate access if need be. This could cover insurance excess payments, or a burst water heater/geyser. These funds are not for holidays or X-Box games.

My ideas that an emergency fund could be used for are:

Job loss, expensive car repairs, medical emergencies (if you got no health benefits), funerals, plane ticket if a family member needs your assistance and lives far away etc.

But as the balance of your fund grows don’t be tempted to dip into it for something you think might be an emergency but actually isn’t.

If you already have an emergency fund that’s brilliant, the vast majority of people always say. We`ll be ok, I’ll start it next month. Or we can use the credit card for anything that crops up. My personal goal of becoming a Wealth Titan is to avoid using credit cards and always having the cash to pay for items that I want or need. I still got debt to pay off and we getting there slowly but surely, but I am relieved that I started my emergency fund a little sooner than later.

Also remember that if you have no or little debt, your emergency salary funds don’t need to be as high or you could stretch it out for longer periods while looking for new employment. Also with little or no debt you would probably have additional money each month to spend / save / invest as you deem necessary.

Please comment if you have a different method of dealing with unexpected expenses.