How to Get out of Debt With the Debt Snowball Method
Debt- whether it be from loans, credit cards, or unpaid bills – can quickly become debilitating and overwhelming. Debt will steadily worsen your credit until your credit score is so low that you can’t buy anything of value. It keeps you from purchasing vehicles and obtaining property. Debt can even threaten your home, since mortgage lenders can foreclose on your home if you default on a loan. It’s important to reduce your debt as much as possible to avoid these disasters. The debt snowball method can help you do just that. Let’s look at how this method of debt reduction can help you.
Debt Service Coverage Ratio
Debt service coverage ratio is a term that is usually applied to small businesses and corporate finance, but it can be used to refer to individuals as well. It is a ratio that compares cash flow to debt obligations. For individuals, it would compare income and assets with debts. Your annual net income is divided by your annual debt payments. You want to shoot for a ratio greater than one, as this will indicate that you are in a good position to cover debt and loan payments. The higher the number, the better your standing.
Lenders often use this figure to determine an individual’s ability to pay the upfront costs, repayments, and interest rates associated with a new loan. It tells them whether you can pay on time and in full each month. This in turn helps to determine your eligibility for the loan, the interest rates to charge, the loan amount, and other terms for the loan.
However, it’s not just about having enough cash to cover loan repayments right now. Lenders want to know you have a cushion of sorts, meaning you can comfortably repay the loan without impacting your standard of living. If you would have just enough money to repay the loan, you might start to struggle with it if a large expense came along, such as a family member who got sick and needed medical treatment. Lenders typically want to avoid this scenario.
This is why a debt service coverage ratio of one is not good enough. This number does not leave room for a cash cushion. Many lenders will accept borrowers with ratios of 1.35, though they may go as low as 1.10 or as high as 1.5.
The usual way of obtaining a debt service coverage ratio is to simply divide income by debts, but different lenders might arrive at the number by different methods. There are several ways they might calculate the ratio. When you are first applying for loans, you should ask the lender whether they check debt service coverage ratio and how they calculate it.
There are a few steps that are common in calculating debt service coverage ratios. First, net income is determined. For businesses, this means taking revenue before interest, taxes, depreciation, and amortization. For individuals the process is simpler. Use your annual income before taxes. Next, you look at debt payments. Add up annual payments for all existing debts, such as loans and credit cards. This could also include loans that you are applying for. Then divide the annual income by the annual debt.
If you find that your ratio is too low to obtain a loan, you’re not doomed. There are two steps you can take to improve it:
- Increase your income. This may involve asking for a raise, moving into a higher-paying position, taking a better job at another company, or making the switch to an entirely new career.
- Decreasing your debt. The debt snowball method can help you reduce debt, thus improving your ratio.
Debt Snowball Definition
Debt snowball is a method of reducing and eliminating debt. It is intended for individuals with several different debts, such as loan payments, credit card bills, and others. It can help you slowly but steadily raise both your credit score and your debt service coverage ratio.
With the snowball method, you pay off smallest debts first. Once the smallest one is paid off, you use the money that used to go into it to pay the next smallest. You keep rolling the money from one debt to the next until each one has been paid, from the smallest to the largest.
You begin to see the rewards of your hard work right away. Each debt, no matter how small, that gets paid off provides a small victory and a feeling of satisfaction.
The steps involved in using the debt snowball method include:
- Budgeting for minimum payments. You need to make minimum payments on each debt to keep them from ballooning out of control before you can get to them. This is especially important for mortgages and car loans which could cost you your home or vehicle.
- Disregard interest rates. Some methods of debt reduction prioritize debts according to interest rates, but for the purposes of the debt snowball method, you only want to look at the total balance of each debt. That being said, if the largest debts also come with high interest rates, you may want to consider consolidating them so they will not continue lowering your credit score before you can get to them.
- Arrange the debts from smallest to largest.
- Set aside extra money for eliminating debts. Once you’ve budgeted for minimum payments, set aside some money for paying off debts above these amounts.
- Apply the money to the smallest debt. Don’t try to divide it among all your debts – the goal is to focus on one at a time.
- Roll money over to the next debt. Once the smallest debt is paid, take all the money that was going towards it, including minimum payments and the extra money, and apply it to the next debt.
- Keep rolling. As each debt is paid off, you will free up money that is no longer going towards monthly payments or getting set aside. Roll all of it over to pay the next debt.
The Debt Snowball Method – Control Your Debt
Debt can really feel daunting to deal with. Determining your debt service coverage ratio and using the debt snowball method to improve it are two effective methods for dealing with your debt. You will eliminate more than just your debt – you’ll get rid of stress, too.
Resources – Debt to Income Ratio/Credit Score
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