The other day I wrote about Dave Ramsey’s Debt Snowball, a method for quickly and effectively paying off your debt. The concept is fairly simple: list your balances from lowest to highest and pay minimums on each bill except for the lowest bill, to which you will send as much extra cash as possible each month. Once that bill is eliminated you use the payment you were sending to the bill you just paid off, add it to the payment you are already sending on the next lowest balance and you repeat the process until each bill has been repaid.
What’s Wrong With the Debt Snowball?
To be honest, I think the Debt Snowball is a great way to repay debt because it is organized and focused. That said, there are a couple reasons that many people have issues with this concept. The first is that Dave Ramsey recommends paying the lowest balance, regardless of the interest rate. His belief is that the quick wins will be the motivational factor most people need to keep going. Mathematically, his method is not the best, but it puts mind over matter, which is half the battle. (To those who use the math argument as a reason against using the debt snowball, also consider that paying off the lowest balance first increases cash flow, which can give people more financial flexibility).
Another issue with the Debt Snowball is there is no distinction made between secured and unsecured debt. And there can be big problems with not paying secured loans – foreclosures and repossessions being at the worst end of the spectrum.
Should the Debt Snowball Address Secured Debt?
I recently received this reader question regarding the order to repay the debts. I would normally just send a link to the debt snowball or Dave Ramsey’s Baby Steps for most similar questions about repaying debt. But in this case, I felt obligated to go against the popular money guru’s advice. I’ll share my answer, and I’m interested to know how you would handle a similar situation.
I am hammering away at my debts. In the past year I have paid off about $10,000 in debt, but still have a ways to go. I have the following debts on top of a $128,000 mortgage:
- HELOC: $14,200 @ 10% interest,
- Auto loan: $8,800 @ 7.55%
- Student Loan 1: $29,000 @ 4%
- Student Loan 2: $3,200@ 4.55%
I want to know which debt I should attack first. Also, I will most likely be getting a bonus at work in the amt of $15,000 after tax. I feel like I should eliminate that HELOC first, is that right?
Thanks for contacting me, and congratulations on making so much progress eliminating debt! There are dozens of ways you could attack your debt, but here is what I would do.
Address the secured debts first
Your bonus is a huge blessing and unless you have other pressing needs at the moment, I would recommend using it to eliminate your HELOC (the only needs I would prioritize above this would be paying your mortgage or establishing an emergency fund to help prevent the need for taking on more debt).
So long as you are good with those two areas I would eliminate the HELOC first, for these reasons:
- It has the highest interest rate,
- It will probably increase your cash flow the most,
- Most importantly, your house is used as collateral for the HELOC (if you default on the HELOC you can lose your house).
It’s awesome that your bonus will enable you to eliminate the HELOC in one fell swoop. It may not be a bad idea to close the HELOC if you don’t have any need for the loan in the near future.
Next steps: After the HELOC is repaid I would still use the debt snowball concept, but again, I wouldn’t repay the lowest balance loan. I would make the minimum payments on everything except the car loan, which I would pay extra toward until it is eliminated (again, because it is a secured loan and it has the highest interest rate). Then repeat the process with your remaining loans. I would probably order them as the car loan, followed by the smaller student loan, then the larger student loan.
Final thoughts. I think DR’s Baby Steps is a great process, but HELOCs can be a dangerous type of loan because they are tied to your home. I think it’s a wise decision to pay it off right away if you have the means to do so. But there are many ways you can pay off your debt, so choose the method that you feel most comfortable with.
The key to success with this is paying extra on your debts in an organized way so you can eliminate them more quickly – an example is using a debt snowball spreadsheet to help organize your payments. You will be successful as long as you are paying extra and not adding new debt.
How would you handle repaying these loans?