Personal Finances Debt Freedom System

Personal Finances Series – Debt Edition

TLDR Summary Version:

• Snowball Method: Pay off smallest debts first for psychological wins and motivation.
• Avalanche Method: Target highest interest debts first for mathematical efficiency.
• Balance Transfers/Consolidation: Use 0% APR offers or personal loans to reduce interest, but be cautious.

Additional advice:

• Creating and sticking to a budget
• Debt to Income Ratio
• Avoiding new debt
• Negotiating with creditors

Step 1 to any Debt Repayment Plan, a Zero-Based Budget

You’ve decided you wanted to get rid of your debt, but you don’t know where to start and how to be most effective with the money you have.

Before even considering any methods we discuss below, your first priority should be establishing a budget, preferably a zero based budget (check out my article Zero Based Budget Guide.

A financial wellness survey found that 65% of zero-based budgeters reported lower financial stress levels after six months of consistent use.

We wont beat a dead horse on convincing you to have a budget, but I will ask a few questions – Are you financially stressed? Do you know how your spending every dollar you earn, and are you being effective? Can you ensure your maximimizing on your debt repayments?

When we started a budget, we didn’t necessarily immediately feel relief – but we did feel immediately empowered, we knew exactly what our money was doing and where our problems were, which opened the door to problem solving, which eventually led to relief. We knew exactly what we needed to do, how long it would take, and could track our progress throughout each month to make sure we were staying on track.

We created a zero-based budgetting app to make sure you could feel the benefits of budgetting as well. We utilized our experience of having used different budgetting apps on our journey, to create something we think will help people manage and understand their budget faster and easier. Check it out at PeacefulMindfulPocket.

Debt to Income Ratio and Why it matters

The next thing to consider is your debt-to-income ratio (DTI). Simply, this is how much goes out of your pocket each month (mortgage, car lease, student loans, credit card minimums) vs. how much is coming in (gross income). For example, if you have $6000/month in your pocket, but you need to spend $2000/month on all your payments, then your DTI is (2000/6000) x 100 = 33.33%.

Why does this number matter? It’s used by lenders to determine if you should be approved for a loan or credit card, and what your interest rates may be. 50% or higher DTI is considered a financially stressed state and will result in being declined for credit cards/loans or receiving them at higher interest rates. On a personal level, it also means you need to be taking some immediate actions to reduce your debt. On the other hand, if you’re below 36%, it is considered a “healthy rate” and everything in between is usually seen as room for improvement.

Snowball Method

This method targets all your extra savings towards your smallest debt first, regardless of the interest rate (while still continuing to make minimum payments on any other loans you have). The priority here is to pay off your smallest debt as quickly as possible to provide you with more immediate relief. Once you’ve completed payments on that first debt, you roll the payment savings into the next lowest debt quantity you’re targetting and keep growing your snowball that way.

But doesn’t everyone always talk about making your money go the furthest, isn’t this contradictory to that principle? Here’s what people often miss: behavior (see my blog Why is Personal Finance Dependent on Your Behaviour?. To put it simply, we need those psychological wins to keep us going sometmes. Having the positive momentum of clearing one debt, then another, and not only feeling the gains from those short terms wins but also feeling the strength from the growth of your snowball, can be a better long term strategy for making behavioural adjustments then emotionally trying to force through holding out for months or years to pay off one larger loan.

We also mentioned DTI earlier – being able to clear off some of those smaller loans quickly can help improve your DTI score, and open up options for you to receive promos for lower interest rates that you can take advantage of (we’ll discuss this more in a bit).

We personally have utilized this method and it worked great for us. It felt amazing to both watch our snowball grow and clear off smaller loans. By the time we were looking to hit some of our larger loans, we had grown our snowball so much that the impact we were making on larger loans were significant punches and moving much quicker.

Dave Ramsey has a free debt snowball calculator that provides you with the date you’ll achieve debt freedom: click here to check it out. We’ve found the tool extremely useful when looking to see how much of a boost we could throw at our debt payments and what kind of impact it would make.

I want to walk you through why this tool along with the snowball method is so powerful, because it can be difficult to grasp how focusing your efforts in even a small way can make such a difference:

If you had a household income of $6000, and you had the following debts:

1. Several credit cards for a total of $10,000 at roughly 18% interest with minimum payments totaling $200/month

2. A car loan for $20,000 at 5% interest with minimum payments of $400/month

   • If you continued with just making the minimum monthly payments, it would take you from November of 2024 to September 2032 to complete payments -$600/month or 10% of your income for 8 YEARS, along with over $11,000 in interest payments!

   • Using the snowball method to target a debt combined with the insight of zero based budgetting, you can shoot to boost a targetted payment of $150/month. This drops down your debt repayment time to November 2028 - half the amount of time it would have initially taken you, along with saving almost $6000 in interest payments. All for just scraping in an extra $150/month.

Avalanche Method

Now with this method, you do target your highest interest debt first while making minimum payments on any remaining debt. This method targets compounding interest and is usually said to be the most mathematically effective way to pay down debt. It follows the same principle as the snowball in the sense of targetting one debt at a time and utilizing a growing “avalanche” to pay down the next target and so on. The main clear benefit is by paying the highest interest debt first, you save the most money in the long run by avoiding compounded interest.

Honestly, we only recommend this to people who are in a good place in life, money and stress wise. If you just need to clean things up in your finances and don’t have heavy pressures and stresses active, then this may be a good option for you to pursue. While it sounds minor, we personally have found that most people need those small wins from the snowball method to actually see those long term goals come to fruition. Take a look at your budget, the state of your DTI, and your personal state of stress to help you determine which method is a better option for you to work with.

Balance Transfers and Consolidations

Do you get excited when you see an email promo for 0% introductory APR? Your first instinct may be to avoid opening another credit card, but if you’ve got a high interest debt, AND you’ve been progressing through your debt repayment plan, it can be beneficial for you to take advantage of doing a balance transfer to a 0% APR promo. That “and” is a major one. We do not recommend opening another credit line or loan if you have not spent any time working on solving the behavioural problems that got you into debt in the first place. As much money as you think you’ll save through lower interest, we can almost guarantee you won’t. Instead, you’ll find yourself spending more and more with the available space you’ve tricked yourself into thinking you’ve opened up.

If you’ve put the work in and feel confident about the behavioural changes you’ve made and want to proceed down this path, there are a few things we recommend you check out with this option. First, check out what the fees are for a balance transfer. Sometimes, it’s just not worth it to rack up more debt in fees then what you save on the interest. Next make sure to verify what the interest conditions are after the introductory period is over, or you may find yourself in a worse positon when that 6 months - 1 year intro period runs out. Verify how long that introductory period actually lasts, and make sure your debt repayment plan either can cover it during that period, or gives you enough time to drive the number low enough for it not to matter.

My last personal take on this: I’m not particularly against credit cards, but I wanted to reiterate that I have found that if you have not gone through the behavioural adjustments necessary to wtihstand having a new credit card with an available balance, then this wont be the best path forward for you. If you were a client, I would ask: You know yourself better then I do – will you only use the new credit line to pay off your old debt at the lower/no interest, or will you slip and keep adding to the balance? Your ability for honest dialogue with yourself here is critical, as no one else can tell you with certainty what the right path is for you.

If an intro APR/balance transfer isn’t an option for you, the other option is to look at consolodating your loans under a personal loan, if you can receive lower interest rates. We recommend to proceed with caution – research the company you’re taking a personal loan from, what the terms are, and calculations of how a higher debt balance with lower interest may work for you. Sometimes the rates your offered just won’t make sense to consolidate, even if they’re lower. If you’re utilizing the snowball method for debt repayments, keep in mind the emotional toll it may take to consolidate to a larger loan.

We have no affiliations but will share that we personally have utilized Lightstream (https://www.lightstream.com/) for personal loans. We’ve found they offer decent rates, have had no issues with them, and the process for applying/recieving the loan is quick/easy/understandable.

Another major watchout I wanted to note here, we’ve had clients fall into the trap of companies that will “manage” your consolidation via making payments to your lendors on your behalf. That “service” they are providing you means that your debt payments will now also include a fee you pay THEM as a management company for this service. We don’t recommend this, and would go as far as to say it’s outright scammy behaviour that takes advantage of people’s lack of knowledge. They often don’t make their fee’s clear, and in our experience of dealing with this, our client didn’t even realize that a portion of their payment was being taken out as a fee. It also robs you of being able to utilize the debt repayment strategies we discussed earlier. Don’t fall for this!

Stop Using Credit Cards / Avoid New Debt

We know this is a touchy subject, and we are a bit split on it as well. As much as Dave Ramsey toots cutting those credit cards and yelling “Screw Credit Scores!” we understand that some just don’t have that option, right at this minute. Maybe you need to rent an apartment, or lease a car, and you’re just not in a place where you have the savings to pay cash, nor the support to get you through the gap. Sometimes prioritizing your emotional/physical well being is the most important and crucial step you can take before considering tackling your finances. We recommend that if you are going to get a credit card, or keep your credit card once your debt’s paid off, that you set up autopay for the full amount each month. Use a zero-based budgetting app (like ours!) to make sure you stay on top of your finances so that you’re not spending beyond your means and doing the upmost to pay off debt.

Personally, we closed all our credit cards except one once we completed our debt. Yes, it did hit our credit score to do this - we dropped from 800’s to 700’s. The reason your credit drops when you close accounts, even though your DTI is great, is due to a drop in the average age of your credit along with your total available credit. For us, it was worth it to not have to keep tracking accounts that we had no plans to use, and having to worry about putting safety measures in place to prevent fraud. With our 1 remaining credit card we pay it off at the end of each month, so we never worry about debt or interest rates, and we’ve been able to take advantage of some great benefits with reward points.

The Power of Negotiations

Everyone always avoids those creditor calls. We get it, they’re not only annoying, but they can be rude and almost threatning in their speech. Here’s a different perspective we offer: They just want to make sure they get the money you owe, and often getting to speak to you and work out a plan with you is a huge step for them (as most people avoid them or just hang up). Take advantage of this by being the one to call them FIRST, with your numbers and a plan in mind.

One of the best financial win feelings was when we negotiated a debt down from $9,000 to $5000. We’d been making minimum payments for years and figured they might be happier just being done with us, we were right to the tune of $4000 in savings. Sometime’s calling up your creditor, and having a chat with them about your options is well worth the time. Go in there knowing your numbers, and knowing what you can offer. It doesn’t always work out, but as they say, it never hurts to ask.

Conclusion

Whichever method you go for, having a budget with your goals in mind and a way to track your progress is absolutely necessary in managing the stress associated to financial debt. Make sure to utilize a budget to keep you on track in your debt repayment strategy.

If you need help reviewing your budget or your debt situation, feel free to schedule a free consultation (through Calendly) with me here.

We hope this was valuable to you! Feel free to comment any questions or issues you have!