Paying off debt often seems like an insurmountable task. The bills keep piling up as you try your hardest to pay them down, and the stack never seems to shrink. This is as true in business as it is in life. Different financial advisors all have different methods they preach for paying off debt and, in actuality, all of them work.
What works for one business owner, however, might not work for another, and that’s where the value of these different methods emerges. Some people are motivated to continue chipping away at their business debt, because they know over the long run they’re paying less in interest to banks and lenders. Others are more motivated by the possibility of seeing their loan and credit balances decrease quickly.
The Snowball Method was conceived to help decrease credit balances quickly. Here’s how it works, and where its appropriate.
What Is the Snowball Method?
The Snowball Method of paying off debt refers to the concept of starting with something small and building or rolling it into something larger and more powerful. In the case of debt, you line up all your debt from smallest to largest, regardless of interest, and pay off the smallest first. You pay only the minimum on the other debts and concentrate funds to pay off the smallest as soon as you can.
Once the smallest debt is paid off, you take that money and combine it with the next smallest debt, combining funds into larger monthly payments. As you can see, this creates a snowball effect, since the payments get larger as you pay off your various debts.
How to Get Started
First, many financial advisors will recommend that anyone—including small businesses—have an emergency fund set aside. The amount varies, but for most businesses, advisors suggest a six-month cushion. The Snowball Method encourages anyone who wants to start this method to have this six-month rainy day fund already established first. While you’re waiting for that money to accumulate, continue paying the minimum payment amount on your debts, and, most importantly, stop incurring more debt.
Once your six-month fund is set aside, take a look at all of your debts and order them by the smallest amount owed to the largest. Next to each one, make a note of what the minimum monthly payment is. Unlike the Stack Method, pay no attention to each debt’s interest rate.
Now, the tricky part: Examine your budget and determine how much additional money you can put toward debt repayment. This process could take you minutes or days. Chances are you’ve been conducting business outside of your means for a while, in which case, you will have to take a hard look at your finances to find that extra money.
Pull your financial statements apart and look for cost savings that could free up some cash. For example, ask yourself questions like:
- Do I need to rent three copiers for my office? What would you save every month if you only rented two, on the rental fee, toner and paper?
- When’s the last time I negotiated the rates on my outstanding contracts? Call up your providers and see what type of break they may be able to offer. Even a savings of $100 adds up.
What you’re really looking for here is the equivalent to your Starbucks Latte every morning. While that $5 may seem trivial when viewed from a daily perspective, it really adds up throughout the year. It’s the same thing with business. There are small expenses lurking everywhere that, if you cut them, you may not miss after all.
Start Making Payments
Once you’ve determined what your extra debt repayment amount is, you can start paying down your debt. Let’s say you have four debts you need to pay:
- Debt 1: $5,000 balance ($100/month minimum)
- Debt 2: $7,000 balance ($100/month minimum)
- Debt 3: $8,000 balance ($120/month minimum)
- Debt 4: $12,000 balance ($200/month minimum)
You’ve determined you can afford an extra $500 a month toward debt repayment. So, you take that $500 a month and add it to the lowest debt’s minimum payment of $100 per month for a total monthly payment of $600. In a little over eight months that debt will be paid off.
Once that debt is paid off, you take that $600 and apply it to the minimum payment on the second lowest debt. You are now paying $700 per month and would be able to pay off that debt in a little over 10 months. You are now forming your snowball by adding the previous debt payment amount to the current debt. Repeat this until you get to your final debt payment, and you are now paying $1,020 per month to pay off that balance.
Through it all, continue making the minimum payment on your other debts. The last thing you want is to fall behind on a bill and get slapped with hefty late fees.
Using the Snowball Method, you will be debt free in 32 months, as opposed to 61 months if you only paid the minimum amount on each.
Pros and Cons
The most obvious pro is the amount of time it’ll take to pay down your first debt. The prevailing theory is that folks who spend excessively using credit are typically impatient. The assumption is to use that impatience—the idea that he or she uses credit to get what he or she wants NOW—as a better motivator to pay down debt faster.
Detractors state that using the Snowball Method actually leads to paying more in the long run because it ignores interest rates. Additionally, by not paying attention to interest rates, the numbers above are skewed in regards to how long it may take to pay off a loan.
For example, if the interest rate on Debt 1 is 10%, then every month, there would be an additional balance on the loan amount equivalent to 10% of the current balance. The higher the interest rate, the higher this monthly fee is, which could significantly affect how long repayment takes.
Determining the best debt repayment method for you and your business is the first step toward gaining financial freedom. Whether it’s the Snowball Method, the Stack Method or another method entirely, it’s important to pick the one that will work for you and keep you engaged with the process so that you can continue to pay off your debt. Because in the end, a zero balance is really the only metric that matters.
Debt isn’t the only thing you should be worried about when looking for signs of a business’ failing health. Here are six more signs of poor financial health you need to pay attention to when assessing your business’ condition.
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Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.