4 Best Strategies on How to Pay Off Debt
Debt is something that most people will face at some point in their life.
Whether you’ve taken out student loans, needed a car and haven’t had the cash, or took out a mortgage on your house, debt is a scary thing.
When you have multiple creditors it can be difficult to track all the minimum payments, due dates, and balances, making your debt seem insurmountable.
There are multiple payment strategies that can help you get out of debt, but each is best suited to a different financial situation.
1. Smallest Balance First
Having debt can take a big psychological toll on a person.
Endless bills, interest charges, and more coming at you from all sides is tough.
People on a tight budget can also really struggle if they have multiple debts.
All of the minimum payments added up will be higher than the minimum payment would be if all of the debts were combined into one.
This leads some people to target the smallest balance loans first, that way they can reduce the number of bills they have over time.
Use the following as an example: you have a $4,000 car loan, $950 credit card loan, and $20,000 in student loans.
The minimum payment on the car is $150, the minimum payment on the credit card is $40, and the minimum payment on the student loan is $400, and you have $650 to put towards your loans.
This strategy would have you pay the minimums on the car and the student loan, and pay $100 towards your credit card.
By following this strategy, you would pay off your credit card debt in ten months, compared to more than four years at the minimum payment (assuming no interest charges).
This brings the dual benefit of leaving you one less bill to deal with every month and it frees up an extra $40 a month to deal with other bills.
The psychological benefit of having fewer bills coming in each month is large, especially if you have a lot of loans.
Receiving a notice that the debt has been paid off also feels like an accomplishment.
Paying the smallest balance first is a good strategy for people who have very tight budgets and need to free up the extra money that goes towards the minimum payment.
It is also best suited for people who need regular reinforcement from seeing their debts paid in full.
The main issue with this strategy is that it is you will most likely wind up paying more interest over time.
If your car loan has a 2 percent interest rate, your student loan has a 5 percent interest rate, but your card still had a 0% introductory rate, you would have paid less money in total by putting the extra cash towards those loans.
2. Highest Interest First
This strategy is best for people who do not have cash flow issues and who have the dedication to continue a payment plan even when the visible results are less immediate.
In the long run, this strategy will result in less interest paid and a shorter time frame for paying off all of your loans. Despite this fact, it can be difficult to stick to the plan without a lot of perseverance.
Let’s expand on the example above:
If you make the minimum payment on your student loans each month, it will take 22 years to pay the loan in full. You will pay a grand total of $25,158.93 to pay off a $20,000 loan, more than $5,000 in interest.
Instead of deciding to put the extra $60 a month towards your credit card, which has 0% interest, you put it towards your student loans.
You pay $460 every month until you have paid the debt in full. Instead of taking 22 years and pay more $5,158 in interest, it will take you 4 years and a month, and you will pay $2,111.38 in interest.
The results are far less immediate than paying off a smaller balance loan, but targeting high-interest rates will save you a lot of money in the long run. It will also reduce the total time it takes to pay off your debt.
It can be difficult to stick to a payment plan without immediate evidence of the benefit of your hard work.
Keep in the mind the fact that if you can persevere, you will find yourself in a better financial situation in the end.
If you have a large number of loans, especially student loans or credit card balances, consolidation can be a good idea to reduce your payments.
Consolidating your debt sometimes lets you lower your interest rates, making it a good choice for people whose credit scores have improved since they took out their older loans.
The downside is that the process can take a little while since you will need to shop around for the best rates.
If you are carrying a balance on multiple credit cards, the easiest way to consolidate these loans is by doing a balance transfer to a different card.
You can transfer all of the balances to a card you already have if you just want to reduce your minimum payment and number of monthly bills.
The best thing to do if you have a decent credit score is to apply for a new credit card that has a 0% interest promotion.
This lets you eliminate you turn a lot of bills into one and save money in the long run. Just be careful to pay off the whole balance before the promotion period ends, otherwise, you may be charged the interest you were seeking to avoid.
Also, look out for balance transfer fees, which are commonly around 3 percent of your balance, which can cut into the savings.
For loans that aren’t on a credit card, there are a number of loan consolidations options out there.
Many student loan providers and banks will help you combine your loans into one.
If you have accounts at a smaller, local bank, they may have good deals that they want to use to earn your customer loyalty.
If you don’t have a local bank that you can consolidate with, and your student loan providers aren’t being helpful, there are a few personal loans options.
Lending Club is a peer-to-peer lending site where you can take out loans up to $35,000. Each loan is funded by people on the site who are investing their money in hopes that you will pay it back.
Rates on the site are high, between 7 and 26 percent, but it can reduce your payments in a pinch.
Once you’ve paid off your loans you can invest on the site yourself, so long as you live in a state that allows peer-to-peer lending.
Lending Tree is similar in that you can take out a loan for up to $35,000 but it is not a peer-to-peer lending site.
The site gives a list of loans available in your area, as well as the interest rates, making it a good place to go if you want to shop around.
4. Income-Based Repayment For Student Loans
High student loans are one of the major problems facing young people today, with the total balance of student loans in the U.S. reaching more than $1 trillion in the aftermath of the 2008 recession.
These plans can reduce your loan payments to a 10 to 20 percent of your discretionary income, depending on the plan.
If you follow one of these plans and make the minimum payment every month for 20 or 25 years, depending on the plan, any remaining balance will be forgiven.
Income-based payment plans can be a boon for people with huge student loan debts and can help you save a lot on interest payments.
The one thing to watch out for is the fact that the balance that is forgiven at the end of your payment period is considered income for tax purposes. This can leave you with an unexpected bill in the final year of the loan.
If you work for the government at any level or for a tax-exempt non-profit organization then you can have your loan balance forgiven even faster under the Public Service Loan Forgiveness Program.
Under this program, any remaining balance is forgiven after 10 years instead of 20. You can combine this program with an income-based repayment program to maximize your savings.
Not all of your student loans will be eligible for either of these plans.
In general only loans from the government are eligible for these programs, so private loans, as well as loans consolidated through a private loan, may be ineligible.
Despite the requirements, the benefit of these programs can be huge for people with large debts, making them a valuable tool.
The Debt Snowball Method vs. Debt Avalanche
In comparing debt reduction methods, two techniques that are often mentioned include debt snowball and debt avalanche methods.
The reason is quite simple -- they are both, in a way, the same thing.
The Debt Snowball Method
The debt snowball method of debt payment instructs individuals to begin by paying smaller debts in order to gain momentum and traction.
From that point, the success of eliminating those smaller debts will snowball into paying larger debts.
On Dave Ramsey’s site, creator of the debt snowball, he posits that:
“The math seems to lean more toward paying the highest interest debts first, but what I have learned is that personal finance is 20 percent head knowledge and 80 percent behavior.
You need some quick wins in order to stay pumped enough to get out of debt completely.”
The technique is more psychologically geared toward supplying a person with a feeling of accomplishment.
With this method, individuals are instructed to stop payment on everything except for the minimum payment for the other debts in order to whittle down and eliminate the one bill or debt they are focused on.
The Debt Avalanche Method
The debt avalanche method of debt payment works essentially the same way, except the individual is instructed to start by paying off the highest debts immediately, which will crescendo into an avalanche.
Financially speaking, this method will save successful debtors a ton on interest.
So, Which is Better?
Psychologically speaking, it's easy to see the appeal in applying the debt snowball method.
The discouraged individual gets a boost from tackling their payments and the feeling of accomplishment is sufficient enough to bolster their spirits and motivations.
Since many debt problems do spring out of psychological reasons, this method may create more of a substantial spark.
Financially speaking, you can't beat the debt avalanche method of paying down debt.
By eliminating the biggest debts first, they wipe out the biggest source of interest, saving them money in the long-run.
This method is concretely the best for those who want to turn a new leaf and make a huge commitment to being debt-free.
However, the morale boost is not as strong a component in this technique as it is with the debt snowball.
When considering which debt-reduction techniques are right for you, you'll need to take into account personal preference and how much debt you can realistically pay off at a time.
If you convince yourself you'll be able to commit to the avalanche method, the initial feeling of success will be harder to come by.
However, if you know you're a committed person, then prioritizing your debts from biggest to smallest will be a much better value.