Interview at Forbes about debt repayment strategies.
According to the latest data from the NY Fed, total consumer debt is now at an all time high of $13.2 trillion. That equates to an average of over $40,000 owed by every single American across mortgages, student loans, auto loans, and credit cards. So much debt can certainly feel overwhelming and helpless.
For some, debt-free has become the new American dream. However, many people have faced a mountain of debt and successfully climbed out, so escape is within reach. One such person is Marcus Garrett, who paid off over $30,000 in credit card and personal loan debt and now talks personal finance on the Paychecks & Balances podcast.
First and Foremost
Before you can start the journey to paying off debt, the first step is to formulate a plan, according to Garrett. To do that, he suggests using an easy-to-remember acronym (DEBT) to help.
D = Define the problem. Garrett had no idea himself that he had racked up so much debt until he pulled his credit report and did the math.
E = Establish a plan. He knew he wanted to be out of debt by the time he turned 30, and came up with a strategy to do just that. Using one of the many online debt calculators, like this one from Bankrate, can help.
B = Build a budget. Garrett used 50% of his income on needs, 30% on wants, and 20% to pay down his debt. The budget helps you identify where your money is going, where you can make sacrifices, and when you are in danger of overspending.
T = Trust the process. Stick with the plan, even when things get mentally or financially tough.
Focus on Credit Cards
If you are facing multiple debts, focus first on credit cards, personal loans, and other high interest accounts. While credit cards only make up about $800bn of the $13.2 trillion total debt outstanding, it’s the sky-high interest rates (averaging about 15% but often higher than 20%) that can be most threatening to your financial future.
Priya Malani is the founder of Stash Wealth, a financial advisory firm catering to millennials who make a good living but often still struggle with debt. Many of them are using credit cards to finance a lifestyle they can’t quite yet afford. Malani believes that “if you are dealing with serious credit card debt, annihilating it should be your first financial priority.”
Her suggestion is to devote at least 20% of your after-tax income towards credit card debt. Once it’s paid off, then you can start using some of that for other savings and investments instead. Stash does not let clients invest if they have credit card debt, because then you’d effectively be financing investments with a credit card which is going to cost you a chunk more than you’re apt to make.
Paying off Multiple Credit Cards
When it comes to paying off multiple credit cards (and other debts as well), there’s typically two schools of thought in terms of how to prioritize payments. In both cases, you’ll need to make all your minimum payments first so as not to fall behind on any accounts. Where these two methods differ is where to allocate any excess principal payments you can afford to make.
The first method, known as the “Snowball” method, entails paying down the account with the smallest balance first. Once that is paid off, you can allocate the amount you were paying to that card towards your next smallest balance, and so on. In this way, you pay off small debts quickly, and the amount of principal you can afford to pay on each subsequent account snowballs higher with each loan that is paid off.
The second, or “Avalanche” method, entails paying down highest interest balances first. By minimizing the balance of the highest interest account and paying it off first, you’ll be minimizing the total amount of interest you’ll be paying over the life of your loans.
Which Method is Better?
The answer may surprise you. In a perfectly practical world, the Avalanche method would be best because it would get you out of debt sooner and with less interest paid. For some people, this will be the best method. However, most consumers are not perfectly rational.
Simon Blanchard is a professor at Georgetown’s McDonough School of Business and studies consumer psychology. Blanchard argues that “seeing a large chunk of debt removed from a small account is very motivating, and that extra motivation makes consumers work harder at applying money to their debts.” A recent study he published in the Journal of Consumer Research backs this up. Those consumers who paid down their smallest balances first were able to get out of debt quicker than those who paid the highest interest balances first, in large part because the positive reinforcement of paying off that first debt helped motivate those consumers to save even more towards their remaining debts. This is also the approach to pay off debt taken by Garrett, who agreed that “sometimes you just need to see an account at zero.”
Be smart, and take a minute to evaluate your specific situation. Use a free online comparison tool to make sure that one method won’t cost you much more or take much longer than the other. If your balances are quite similar but one has a much higher interest rate than the other, for example, the Snowball method may not make as much sense.
Other Ways to Save
Lowering your interest rate can help you put more of your payments towards principal and get out of debt quicker. One way to do this is to transfer your balances to a credit card with a lower interest rate. Depending on your credit situation, you may be able to find 0% APR offers on balances transfers as well. Most of these offers are likely to charge an upfront fee for any balances transferred so make sure the savings are worth it. You can also look into personal loans from your bank or an online lender. Use any new loan cautiously! Your debt and interest payments will go up instead of down if you don't use the proceeds to pay down existing debt.
Think of your financial fitness like you would your physical fitness. If you have trouble motivating yourself on your own, join a support group (like Debtors Anonymous or Spenders Anonymous) with others who are in the same boat so you can motivate each other. Or, get a coach to help mentor you and keep you on track. This coach could be a financial advisor or someone in your network who has successfully battled debt in his or her past.
Getting out of debt takes a ton of discipline. That discipline will continue to be valuable going forward in keeping you out of debt and financially secure. When you reach the promised land, make sure to stay there. Your budget especially will help you manage spending and save for the future, so you can ensure you never get back into debt again and can instead set your sights on your next American dream.