Three Ways to Get Out of Debt

If you feel overwhelmed by debt, you’re
not alone. In 2019, the average American owed more than
$6,800 across four credit cards. One of the biggest challenges of getting out
of debt is knowing where to begin. Having a specific method can help. Here are three strategies to pay off debt,
especially debt with an interest rate higher than 5%: the avalanche method, where you pay off debt
with the highest interest first, the snowball method, where you pay off the
smallest balance first, and consolidation, where you combine your
debt. We’ll walk through each method to help you
determine which one may be right for you. While it may require some sacrifices, it is
possible to dig yourself out of debt one step at a time. Let’s say you have debt on four different
credit cards. To start, write down all your outstanding
balances and the interest rates on each. Based on these totals, if you only paid the
minimum on each card, you might not be debt free for almost 12 years. With the avalanche method, you’ll prioritize
paying off the debt with the highest interest first. The idea is by focusing on the most expensive
debt first, you’ll save money over time. For the other cards, pay the minimum every
month, then put everything else you can toward paying off the highest interest rate card in
this example, the one with the 22% interest rate. After the highest interest rate debt is paid
off, you’ll apply those payments to debt with the next highest rate, and so on. The avalanche method will save you more money
in interest payments than if you were to pay off lower interest debt first, so mathematically,
the avalanche method is a better way to pay off debt. If you’re able to put an extra $500 per
month toward this debt, the avalanche method could save you more than $21,000 in interest
compared to just paying the minimum. It’d also shorten the life of your debt
to only three years. But for some, avalanches have to start somewhere maybe
as a snowball. With the snowball method, you’ll pay the
minimum of all your balances and put anything left toward the debt with the smallest balance
first. So, in this example, you’d pay off the $1,300
debt first. It may seem financially unwise to pay off
anything but the highest interest debt first, but with the snowball method, you’re able
to pay off a higher portion of one of your balances with each payment. Take that $1,300 debt: a $500 payment would
pay off 38% of that account while $500 toward the debt with the highest interest rate would
only be 5% of that account balance. A study in the Journal of Consumer Research
found that when subjects paid down a higher portion of a balance on their debt, they were
more motivated to keep going. Though it’s not the most cost-efficient
method, in the long run, it was more effective. Don’t underestimate the power of psychology. The sense of accomplishment from completely
paying off one balance can motivate you to stay disciplined with the others. A third method of debt repayment is consolidation. This is combining all your debt into one,
so you make a single monthly payment, ideally, one with a lower interest rate than your existing
accounts. One way to consolidate debt is to take out
a new loan or line of credit to pay off your existing debt. Another choice is a balance transfer, which
means moving your balances onto a new credit card. This may be a good idea if you’re able to
open a new credit card that offers 0% interest on balance transfers. But typically, this 0% interest is only for
a limited time, like a year or 18 months. So don’t transfer your balances unless you’re
sure you can pay them off during this introductory period or if the new interest rate will be
lower than your current combined interest rate. In our example, if you combined everything
into a 0% balance transfer for 12 months, you’d face payments of $2,500 per month. That’s pretty steep, so make sure you’ll
be able to handle that amount, or you’ll face interest at the end of the intro period. So, to review, avalanche saves money by paying
debt with the highest interest rate first, snowball may maximize motivation by paying
the smallest balance first, and consolidation may be useful if you can afford to combine
all your debt into one payment. There isn’t one right way to dig your way
out of debt. Your numbers may be different than the ones
we used in our example, which means the difference between total payoff could vary from one strategy
to the next. The most important thing is to stop adding
to the debt, determine exactly how much you owe, pay as much toward it as you can, and
stick to it.


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