Maybe you started your adult life without being taught any budgeting skills, or maybe you went through a divorce or put yourself through college and became dependent on credit cards. Whatever the case, there’s no judgment here. My goal is to help give you a plan to pay down your debt and put you on the path to financial freedom with the ability to get ahead with your finances.
Why It’s Important to Get Out of Debt: The Cost of Carrying a Balance
Carrying a lot of high-interest debt like credit cards can cause your balance to add up quickly from accrued interest charges. Here's a simple example of how this works:
Let's say you have a credit card balance of $5,000 with an annual interest rate (APR) of 20% and you're paying the minimum payment of $100 each month.
Month 1: Opening balance: $5,000
Interest for the month = $5,000 * (20% APR/12 months) = $83.33
Minimum payment: $100
New balance: $4,983.33
Month 2: Opening balance: $4,983.33
Interest for the month = $4,983.33 * (20%/12) = $82.72
Minimum payment: $100
New balance: $4,966.05
By the end of month two, you’ve only paid $33.95 towards your original balance of $5,000, even though you’ve paid $200. Over a longer period, the compounding interest rate will make it harder and harder to pay off the original balance, especially if you’re only making the minimum payment—and even more so if you’re adding to the balance by buying more.
Feel motivated to end the cycle? Before we dive into what will sound like a storm (quite literally), here are a few things to do if you are serious about kicking your debt to the curb:
Make a list of your debt including the outstanding balance, interest rate, and minimum monthly payment. Understanding how much debt you have and what it’s costing you in interest is crucial to know when developing your payoff strategy.
Evaluate your income and expenses to create a realistic budget. Allocate a portion of your income to debt repayment while making sure to cover your essential living expenses.
To avoid accumulating more debt and keep ahead of your payment, stop using your credit cards until you've paid off your existing balances.
Comparing Three Methods for Getting Out of Debt
With this approach, you prioritize paying off debts with the highest interest rate first. Start by making minimum payments on all your debts and then allocate any extra money you identified in your budget and apply it to the debt with the highest interest rate.
Once that credit card or loan balance is paid off, move the money you were paying on it to the one with the next highest interest rate, and so on. Each time you wipe out a balance, celebrate because you’re paying an even bigger chunk of change to the next one, which will start to amplify how fast you’re paying things off.
Pro: This method typically saves you money in the long run because you eliminate the most expensive debts first.
Con: If you have a big balance on the debt with the biggest balance, it might take a while to pay it off and feel a sense of accomplishment.
This method focuses on paying off debts from the smallest balance to the largest, regardless of their interest rates. As with the above method, start by making minimum payments on all your debts and then put any extra money from your budget towards the debt with the smallest balance. Once you pay off the balance, celebrate and move the money you were paying on it to the one with the next highest balance, and so on.
Pro: This method provides psychological motivation as you’ll see your debts getting cleared faster, giving you something to celebrate.
Con: It may cost you more money in interest over time compared to the avalanche method.
With this method, you combine several smaller debts, especially credit cards, into one larger one. This is usually easiest to do when you receive a new credit card offer with a lower introductory interest rate, or you get a balance increase on an existing credit card with a lower rate.
Consolidating your debts allows you to make one payment a month toward your debt, and usually at a lower interest rate. Another option is to shop for a low interest debt consolidation loan.
Pro: It’s easier to apply the budget you’ve identified towards paying off debt to this one balance, and you may pay less in interest over time. (Just make sure you pay your bill by the deadline, or you’ll get moved to a higher interest rate as a penalty.)
Con: It can be tempting to pay only the minimum payment due on your new balance rather than applying the total of what you were previously paying towards separate credit cards.
Other Ideas to Get Out of Debt Sooner
Once you have a grasp on and plan in place for paying down your debt, here are some ideas to speed up the momentum.
Increase Your Income: Consider finding additional sources of income, such as part-time or gig work, taking on a seasonal job, freelancing or selling items you no longer need. Using this extra income to pay off debt can accelerate the process.
Work with a Credit Counseling Service: Nonprofit agencies can help you develop a more specific plan for managing your debt. Some will negotiate with creditors on your behalf for reduced interest rates and fees. These types of organizations are typically compensated from the fees paid by consumers to sign up through grants and/or donations and sometimes from the creditors themselves. Make sure to read the fine print to understand how they operate.
Negotiate Lower Interest Rates: Reach out to creditors yourself to see if they are willing to lower the interest rate on your debts. It’s usually in their best interest to do so if you show you’re serious about paying them back. A reduced interest rate can save you money and help you pay off debt faster.
Create a Small Emergency Fund: While focusing on paying down your debt, try to save around $1,000, a figure recommended by several financial gurus. It may prevent you from relying on credit cards or loans in case an unexpected expense comes up. Down the road when you’ve paid it all off, you can set a goal to save three to six months of expenses to prevent yourself from getting back in debt when something big goes wrong.
Ultimately, whichever strategy you choose, the most crucial aspect is to take action now. The sooner you begin, the sooner you'll be on your way to unburdening yourself from your debt and achieving financial freedom!
If you have questions or are not quite sure where to start, you might consider meeting with a financial planner for an unbiased and more in-depth opinion.
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