3 Straightforward Strategies for Repaying Debt
3 Straightforward Strategies for Repaying Debt
Many people are unfortunately all too familiar with the word debt. One could make an argument that just hearing that four letter word can bring an overwhelming feeling of anxiety and stress. However, you’re not alone as many Americans, now more than ever, are drowning in debt. In 2019, the Federal Reserve showed that national household debt stands at $13.54 trillion! To get a better understanding of that figure let’s first understand what debt is and the different types of debt.
Debt is any amount of money borrowed from a person or entity to be repaid at a later date or over time. Many individuals take on debt by making purchases they can’t afford. Agreements are established between the lender and individual with terms on when the borrowed money is to be paid back. There are many types of debt and believe it or not, there is even good and bad debt. Some of the more common types of debt that you might be familiar with are; auto loans, credit card or medical bills. According to Equifax, these examples are traditionally defined as bad debt because they do not provide any value or long-term income, and usually come with high interest rates. Equifax also states that some debt is good debt, like taking out a mortgage to buy a home since home values usually appreciate over time. The same can be true with student loans because your earning potential typically increases with more education. Generally, if the loan provides a financial return to you, it’s considered good debt. In addition to good versus bad debt, you should also be mindful of secured versus unsecured debt. Experian classifies secured loans as a loan where you provide some form of collateral such as your car or home. Should you fail to repay the loan, the lender has collateral, which they can take back for non-payment, thus protecting itself. An unsecured loan, such as student loan, personal loan or credit card, doesn’t have any collateral attached to it. The lender is going off of your credit “worthiness” as assurance that you will repay the debt.
When all of your debt is accounted for, it can be overwhelming to think of how you’ll manage to pay off your debt, particularly if you have a substantial amount. Even when it seems impossible, you can take control of your debt and begin to pay it down by using one of the following strategies.
The Avalanche Method is an approach to eliminating debt in which you go after your balances with the highest interest rate, paying more toward that debt and the minimum on the rest in order to eliminate the most expensive debt first. Tackling balances with the highest interest rate allows you to save on interest that you would have paid, and then dedicate that money to other balances. Below is an example of listing debt by highest interest rate and then paying the minimum:
Credit Card A - $5,600 balance (21% APR)
Credit Card B - $5,000 balance (16% APR)
Personal Loan - $9,000 balance (10% APR)
In this approach, any budgeted money left after paying the minimum payment on each debt is applied to the debt with the highest interest rate, which will eventually eliminate that balance. With Credit Card A’s debt and 21% interest rate payment gone, you can now dedicate all you were paying towards Credit Card A plus the minimum you pay to Credit Card B and eliminate that debt faster. Then repeat the process with each of your debts, adding the money you were spending on previous debts to the minimum payment on the current debt. Depending on your income, this method can sometimes take time to see progress but just like an avalanche, once it gets going, it’s hard to stop and it eliminates everything in its path.
The Snowball Method is a technique in which you pay off your debts in order from the smallest balance to the largest. Like any method of debt repayment, there is a requirement to pay the minimum balance on all debts, but the goal is to create a sense of momentum once a specific card or loan is paid off. The feeling of success in paying off a loan completely will motivate you to continue chipping away at other debts. Below is an example of listing debts from the lowest balance to the highest, regardless of interest rate:
Credit Card B – $1,300 balance (17% APR)
Car Loan - $4,300 balance (8% APR)
Credit Card A - $7,200 balance (19% APR)
Similar to the Avalanche Method, you would pay the minimums on every balance along with paying extra budgeted money to Credit Card B. After quickly eliminating that first, smaller balance, you would take the amount you were paying for Credit Card B plus the minimum payment for the car loan and pay that entire amount to the car loan to pay it off and then continue this method as you work your way through your debts. This strategy can also help with your credit report by allowing you to eliminate the number of accounts with an outstanding balance. It should be noted that if you use this method, you might spend more money paying down your debts if you have a higher interest rate on some of your other balances. Make sure to evaluate your budget and debt to decide which method works best for you.
Debt consolidation is another option to pay off debt such as credit card debt. If you’re dealing with several high balance credit cards, combining multiple debts into one single bill with a lower interest rate might be the way to go and could save you a considerable amount of money. Let’s explore some benefits of debt consolidation:
Debt consolidation may help you reduce your total debt by reducing the amount you’re paying each month in interest. In addition to reducing interest, it can also shorten the payoff period and eliminate the headache of paying multiple bills.
If you have good to excellent credit you may qualify for a balance transfer through a credit card that charges no interest during the promotional period. Work to pay off your balance completely during this time, otherwise any remaining balance will be subjected to the disclosed APR for the credit card. Keep in mind that some balance transfer credit cards may charge an annual fee or one-time balance transfer fee. Be sure to calculate these costs before making any balance transfers to ensure you’re making the best financial decision to help you eliminate your debt.
Another benefit of using debt consolidation to pay down credit card debt is that it could help to improve your credit score. Although initially you may see a small dip if opening up a new credit card, if you’re diligent with making payments on the consolidated balance or even manage to pay it off in full early, your credit score will increase.
Deciding which method to use can be tough but remember, the best laid plan to repaying debt is the one that works for you. Get started by taking inventory of your debt and adjusting your budget to allocate more money towards paying your balances. Once you’ve established which strategy works for you, stick to it and be honest with yourself. It may feel like there is no way out but using some of the above strategies will help get you on the path to financial freedom.
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