In this uncertain economy, making a resolution to get out of debt—or at least to reduce it—is very smart.
Most likely, you have several credit cards, a car payment and maybe even a home equity loan you haven’t used in a while. You want to get rid of all of your debt, but you feel overwhelmed. Where do you start? How do you do it?
Fortunately, personal finance experts have developed some helpful debt-elimination strategies.
Obviously, the first thing you need to do is to avoid taking on new debt as much as possible. Use a debit card for purchases instead of a credit card so you’re spending only the money you actually have. Be careful to avoid the risks in using a debit card, such as overdrafting your account or greater liability if you lose the card.
Next, you need to itemize your existing debt. What is the balance, interest rate and minimum payment due on each account? (You don’t need to include the primary mortgage on your home in this list unless you would like to pay it off early.)
Add up your minimum payments that must be made each month, then figure out how much more you have available to pay on debt. The core strategy in paying off debt is to focus on one account at a time and apply all the money you have beyond the minimum payment obligations to that one debt.
Logic—and math—will dictate that you focus on paying off the debt with the highest interest rate first. The sooner you get that paid off, the less interest charges you’ll pay—and the more money you’ll have to pay off your other debts. This is the quickest way to pay down debt, and it makes a lot of sense for highly motivated people.
That methodical approach may not work for everyone, however.
How to pay off debt in manageable chunks
Financial guru Dave Ramsey recommends making a concession to human nature. People aren’t always rational, and sometimes their motivation wanes. Think about when you try to break a bad habit or lose weight. Positive reinforcement goes along the way in fostering success.
The same principle applies to getting yourself out of debt and on the path to financial freedom. That’s why Ramsey recommends the “snowball” method: Pick your smallest debt and pay that down first. On all of your other accounts, make only the minimum payments so you can apply all extra funds available to that smallest debt.
Why? Because you’ll be able to pay off that small debt more quickly than any of the others. Not only will you feel a sense of accomplishment, but you’ll also be able to apply the minimum payment you were making on that debt, plus all the extra available funds, to your next smallest debt, which you’ll now work to pay off completely.
By the time you get to the third debt, you have the minimum payments from the first two, plus your extra monthly amount, to apply to it.
As your monthly payments grow larger, you’ll whittle away your debt even faster—the way a snowball gets bigger as it rolls down a hill.
Ramsey says that the positive reinforcement of seeing these debts disappear is worth more than tackling a large higher-interest debt where your monthly payments don’t feel like they’re even making a dent.
If you have two debts that are more or less equal in amount, you should tackle the one with the higher interest rate first, but in general, stick with the strategy of working your way from the smallest debt to the largest.
Tips to increase your monthly payments
One way to make that “snowball” grow even faster is to add the “snowflake” method to your strategy. Do everything possible to increase the amount you can pay toward your debt each month: Sell things on eBay, have a yard sale, never pass up an opportunity to earn some extra money, limit your Starbucks visits to once a week, etc.
Take all this extra cash (“snowflakes”) and apply it your current top-priority debt. Make interim payments, if you can, to reduce the principal as quickly as possible. An extra $100 or $200 a month can quickly make a visible difference in your outstanding balance.
Financial advisers are split on whether it’s prudent to augment your debt payments by cutting back on your retirement plan contributions. Some say you should never cut back payments into your retirement plan because compounding tax-free is so advantageous. Others argue that accelerating your debt payments to reduce those high interest charges might justify suspending retirement payments for a while—no more than two years.
One compromise might be if you’re currently paying the maximum allowed into your retirement plan. You could consider cutting back your contribution to the minimum level that your employer matches so that you’ll continue to benefit from those matching funds.
Ultimately, you have to set your own priorities, depending how big your debts are and how long you have to save for retirement.