DEBT SNOWBALL INTO HOME OWNERSHIP
Onika is a young professional, working in a government ministry earning $15,000 per month. Over the past five years she has racked up debt to the tune of $184,000 with monthly payments totaling $5,250. She has is a $300 registered annuity with a cash value of $36,000 and an educational insurance plan from her parents now valued at $9,000 with premiums of $350.
Age 29 and unhappy about her present financial situation, she opened a credit union share and started contributing $350 per month with the hope of purchasing her own home some day. At one of her visits a front line staff suggested that she seek advice from their financial coaching unit to create a plan to get out of debt and turn her dream into reality. With her lunch hour slipping away she asked the advisor for a quick tip who suggested snowballing her debts by paying the smallest debt first then rolling over payments into the next smallest debt. The advisor also suggested cutting back on discretionary monthly commitments including her $1,500 rent moving back with her parents.
Onika’s debts include two credit cards: $7,000 and $12,000 with payments of $400 and $600 respectively. She has a hire purchase account of $6,000 and an unsecured bank loan of $34,000 with payments of $350 and $1,400 respectively. Finally she has a car loan of $125,000 with payments of $2,500. Onika is a bit skeptical whether the strategy might work and if she could really make a down payment by 35, seeing her two largest debts will take over five years to clear off.
Nick’s Advice
Debt Snowball Principle
Whilst we may wish for a more tropical financial strategy, this concept is solid when dealing with multiple debts with various balances, payments and interest rates.
Imagine: a small snowball perched atop a steep hill, it begins to roll and as it moves down the slope it picks up material, gains weight and increases in speed. This is exactly what happens when rolling debts payments from smallest to largest balances – as one debt is repaid its payment is added to the next smallest debt. Each loan installment consists of interest and principal elements, so as each debt is cleared, this money is liberated and then paid towards the principal of the next successive debt. As balances are reduced the monthly-calculated interest shrinks freeing more money to be directed towards principal.
Debt Accelerator
The smallest debt to be repaid organically in its own time but this can be accelerated if started with an extra monthly payment. This debt accelerator can come from adjusting discretionary expenses and in Onika’s case it may include her annuity payments of $300, the old educational savings plan of $250, part of her share savings of say $200 and if she can swing it, give up her rent of $1,500 with a view of moving into her own home. These payments total $2,250, which is then added to her first priority debt.
Calculating Pay Off Date
By freeing up $2,250, Onika can top up her hire purchase (assumed interest: 36%) payment of $350 to $2,600, eliminating this $6,000 debt in just over two (2) months inclusive of interest. The credit card payment (assumed interest: 25%) of $400 becomes $3,000 and this $7,000 debt is also cleared in a little over two (2) months. Whilst this is happening all other debts are still receiving their regular monthly payments and their respective balances are reducing, so by the time the accelerator is added they are paid off even faster. The other credit card payment (assumed interest: 25%) of $600 becomes $3,600 and it is cleared three (3) months later. The unsecured bank loan (assumed interest: 15%) is next with its payments of $1,400 becoming $5,000, obliterating it in five and a half (5.5) months. Finally the car loan payment (assumed interest: 9%) of $2,500 becomes $7,500 and is cleared completely in about fourteen and a half (14.5) months. Onika is then debt free in about twenty-eight (28) months.
Debt becomes Savings
Onika (now age 31) can bump up her share savings by $7,500 (and assuming annual dividends of 2.5%) she will accumulate $378,000 in 48 months. This is added to the money saved in shares ($150 x 28 months = $4,200: excludes initial share balance) plus the cash values from the educational savings plan ($9,000) and the annuity ($27,000 after 25% tax) totaling $418,200. If the credit union computes her debt service ratio (DSR) as $6,000 (40% of her salary) she could probably qualify for a 25-year mortgage of $780,000 placing her in the housing market for about $1,200,000 inclusive of closing costs.
Conclusion
With a systematic plan Onika can turn her debt problem into a debt opportunity and the reality of home ownership.
