The amazing snowball effect of reducing debt

Take me to Harvey Norman and sign me up for that 60-month interest free period – so I can take that TV home today. Keep me away from the car yards or I will buy another one...

My credit card takes a hammering and we keep adding to our mortgage to buy houses, businesses and do renovations. It’s a compulsion (why save up for it when you can have it now and pay 20% more over a loooonnnngggg period).

Luckily there are ways to avoid a money emergency... 

My professional life has taught me a few important lessons. Number 1: You can have too much debt, especially if you're laboured with a significant amount of consumer debt.

When you apply for a mortgage that the banks don’t like it: if you stack up tens of thousands of consumer debt then that extra 20% that you're paying really starts to add up!

I have learned to keep my debt confined. I keep my debt in the following buckets:

  1. Mortgage
  2. Credit Card
  3. Car Loan
  4. Business Debt

These do overlap in areas, but for the most part only allowing these types of debt have allowed me to keep a lid on the addiction.

If you are drowning under a large chuck of bad consumer debt, how do you get out of it?

I can recommend two ways, both ways require you to direct any excess cash you have to the target loan on your list.

Option 1: Pay the biggest interest rate first

Take out a pen or open your notes app on your phone and write down every loan you have and the interest rate you are paying. Then rank the loans by the size of each interest rate.

It is important that you keep making the minimum repayments on all your loans. Hopefully you have a small amount left over each week.

Take aim at the loan that is number 1 on the list.

For example, the repayment is $120 per week. Take the surplus funds you have left over each week, (it might be $25), and apply it to this loan each week so that the principal amount on this loan decreases quickly.

Once you have paid this, you can take a week off and go out to dinner and enjoy the money you would've allocated to that loan. $145 should buy a decent dinner – BUT make sure it is only 1 week!

Now it's time to target the next loan; we could assume the minimum repayment on this is $60 per week. Take the $120 you were paying on the first loan and the $25 surplus you have and apply it to the new loan. Instead of paying $60 per week, you will be paying $205 per week.

As you can imagine, paying more than 3 times the minimum repayment will destroy this loan very quickly.

Once this is paid, shout yourself a night on the town – $205 will buy plenty of drinks.

Just keep on rinsing and repeating this process until all of your consumer debt is gone.

Option 2: The Snowball effect

Take the same list you prepared in Number 1. However, this time list the loans from smallest to largest in terms of the amount owed.

The aim of the snowball effect is to pay the smallest debt first. Say it's $50 to your mum, and she wants repayment of $10 per week for 6 weeks, charging you $10 for the pain and suffering you bring her.

If we assume the same parameters as Option 1, that you have a $25 surplus each week, you would pay her $10 plus $25 for 2 weeks and the debt would be paid.

Your next debt might be $100 and you are paying $5 per week to clear it. You now apply the $25 surplus plus the $10 that you were paying on the first loan, plus the $5 payment. After 3 weeks the debt is gone.

The reward that you get from the snowball effect is you see the number of loans you have go down faster, and by having to pay less lenders, you start to feel like you are getting on top of your problem.

The snowball effect allowed me to kill the consumer debt I had in my early 20’s and get me to a stage where I can manage my non mortgage debt better. I still have a car loan as I can claim a portion of the interest as a business expense. We still have a credit card as we pay for our holidays with the AirPoints we receive from using it, and most months it is paid off as well!! Our mortgage will be there as we use it to help build wealth through business and property.

But we will never get anything on tick again (not only are the interest rate enormous and the fees that are charged terrible), the bank really doesn’t like it when it comes to increasing our mortgage to do more renovations!