How to Pay Off Debt

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When the economy is prospering, debt isn’t an issue. You can pay your obligations of today because you know that you’ll be earning more tomorrow and lenders aren’t worried you’ll miss a payment. But as the economy sank last year, you saw a lot of credit card and loan companies scramble to assess the risk of their borrowers. If you had a credit card balance, you might have seen your interest rate go up. If you wanted to buy a house, you may have had to document your income a lot more stringently than you expected. It’s not surprising because the average household credit card debt, based on the Federal Reserve’s Survey of Consumer Finances in 2007, was $3,039.70.

At first glance that may seem a little low, but remember that a lot of people don’t even have access to credit cards. If you only include families with credit card debt, that value goes up to over $7,000. Ultimately, any amount over $0 is too much because credit card companies charge interest rates in the double digits. High yield savings accounts pay out less than 2% these days, so a double digit interest rate on credit cards is far too much. It’s time to pay them down, here’s how.

Organize Your Debt

The first step in overcoming your debt is organizing it. Compile a list of all of your debts that includes current balances, interest rates, and pay off periods. By putting together this list, you have now taking something that might have seemed enormous, based on its total dollar amount, and turned it into something that discrete and manageable. $10,000 seems like a lot, and it is, but by taking it out of your head and putting it on paper, you are more likely to overcome it. If it’s broken up into several smaller debts, you’ve now gone an extra step and made each one a little more manageable than the $10,000 lot.

Debt Snowball vs. Interest First

At this point you have two options for your approach in which debts to pay off first. The Debt Snowball is an idea popularized by Dave Ramsey and relies on psychology, rather than math, to be effective. List your debts in ascending order based on balance, so the smallest debts are listed first. When you go to pay off your loans, pay extra to the lowest balance debt. When you pay off the smallest loan, take its minimum payment and add it to the payment on your next debt. This creates a snowball effect, as minimum payments from each retired loan are put towards larger loans, which can help you pay off debt faster and give you a morale boost with each retired loan.

An alternative is to list them based on the interest rate, paying down the highest debts first. By paying the high interest rate first, you are minimizing how much interest you are paying to the credit card or loan company. It’ll be much harder though as you won’t be building quick wins into your strategy, unless you’re lucky and the high interest debts are also your smallest balances.

Build a Zero-Based Budget

Now that you’ve established an approach to paying down the debt, the next step is to find the money. The best way is to create, update, and stick to a budget that accounts for every penny you earn and every penny you spend. You can use tools to help you budget or rely on pen and paper, the hard part is creating that budget and sticking to it. Are you familiar with the old adage “Pay yourself first?” It’s “Pay your debts first” now, so budget a dollar amount towards paying down your debts and stick with it. Account for every last penny.

Reduce Interest Rates

Once you’ve established a strategy and you’ve found a few extra dollars to put towards your debts, it’s time to reduce the interest rate of that debt so you can pay it off faster. There are a variety of strategies you can use but ultimately it comes down to finding cheaper alternative sources of debt.

If your debt is in the form of credit cards, consider turning to a 0% balance transfer. Many credit card issuers are offering a 12 or 18 month period of no interest credit card debt. You can use this time to catch up on payments, just be sure to check the post-promotional interest rate.

If you have other debts, consider a social lending network like Prosper or Lending Club as a way of lowering your interest rate. Through those services you can consolidate your debt at lower interest rates by tapping on a network of investors. The process can be a little draining but many people have used them to lower their interest rate and get out of debt.

Once you’ve consolidated your debt, setup a payment system and found money through budgeting, the key is sticking with your plan until your debt is fully retired. It’s not impossible and many people have done it and with this system in place, you’re well on your way to success!

{ 3 comments, please add your thoughts now! }

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3 Responses to “How to Pay Off Debt”

  1. davidmad1 says:

    Thanks for the valuable, informative article.

  2. Vince says:

    Very useful article for those needing a plan for debt reduction. I approached my debt by paying the highest interest rate cards first to save money over time. One additional strategy is to pay the highly utilized credit cards to improve your credit score and, perhaps, increasing the chance that you will obtain a lower interest rate transfer offer. One additional argument for the snowball approach is achieving a zero balance then the credit card company offering a zero or low interest rate transfer offer. When I did this 3 years ago I was able to reduce the average interest rate from 16% to 7% over a three month period. Now my highest interest rate loan is 5%

  3. Pinchapenny says:

    I encourage people to use a combination of both of those methods. I agree with Dave Ramsey that building quick success is important. However his plan can actually cost you a fair amount of money if done vs. paying of the highest interest rate cards first. So I suggest pay the lowest balance first to build quick success. Then move to a the card with the lowest balance at a high interest rate. Knock it out quickly while still building debt paying confidence. Then move to your highest rate debt and pay those off till you are completely out of debt.
    Another suggestion is after you have paid your first card, head to the bank with the proof of paying it off. Tell the loan officer you are serious about getting out of debt and are looking for better options. Ask for a personal loan for say a few thousand dollars that you can put on a credit card. Then pay the bank (typically there rate will be much lower than the credit card) this can save you a lot on interest.

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