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Select the best strategy to pay off debt
Paying off debt can sometimes seem insurmountable. But it may help to think of it this way: your debt burden comes from two factors. One factor you can control and one you can’t. If you’ve had a lot of fun in the past, like going on trips, buying new clothes, or a new car, you have made the decision to pay for those things in the future. The future is now.
Alternately, there are always expenses you didn’t choose. For example, medical bills, new tires, and plumbing repairs are not usually purchases you want or plan for. However, you should because they are affecting your financial security. Acknowledge that something will come up that you didn’t plan for, so budget for it now.
Paying off debt should be straightforward, right? Generally, yes. But there are a few strategies that can help you achieve your goal.
Identify Your Debt
Start by making a list of all your debts and how much you owe. Include your revolving loans, like credit card balances, as well as your installment loans, which are student and car loans, and mortgages, etc.
For each credit card and loan, note:
- The balance of what is owed
- The minimum monthly required payment
- The interest rate charged on the debt
Note All Monthly Expenses
These show up in your bank account, on credit cards, debit cards, and cash withdrawals.
This list includes your monthly expenditures for rent, food, gas, utilities, phone, internet, streaming, pet food, etc. To clarify, these are things that must be paid that are not on either a revolving loan or an installment loan.
What Can You Do Without For Awhile?
As you examine your monthly expenses, note exactly what you are spending your money on. Then, see if you could cut back on something while you’re prioritizing getting rid of your debt.
While making your debt pay-off a priority, you might decide that eating and drinking out is a big expense you could limit. Likewise, you may decide that you have enough shoes for now. This is a strictly individual assessment of where you can find funds for your new priority.
The Importance of an Emergency Fund
While it may be counterintuitive, the best way to pay off debt is to save money.
The best financial habit you can start is saving money first, before you do anything else with your paycheck. To do this, simply choose an amount and set up an automatic transfer to your savings account after each pay period.
Your first goal is to build an emergency fund. When you have an unexpected expense, use the emergency fund to cover it. You’re reducing your debt on credit cards by saving the money in advance.
Recommendations for the amount to save vary. Some say three months of your salary while others say six months or more. Choose an amount you’re comfortable with and that you believe you can achieve.
Do the Math
- Start with your monthly income figure.
- Subtract your monthly expenses, the money you spend to live.
- Subtract the amount you’ve chosen to auto-transfer into your emergency fund.
- The amount left is what you’ll use to pay off your debt.
Different Strategies to Pay Off Debt
The experts often cite three different strategies for tackling debt. These include the snowball method, the avalanche method, and consolidation.
Pay Off Debt Using the Snowball Method
In both ‘snowy’ strategies, snowball and avalanche, you pay the minimum required payment on all debts, except one. On one, you’ll pay the most you can afford.
In the snowball method, you choose the debt that has the smallest balance. This bill gets the extra money while the others get the minimum payments.
After that small bill is paid off, move the extra payment to the next largest balance. You’ll be able to pay more on that balance because you don’t have the previous bill anymore.
A snowball gets bigger the more you roll it. Likewise, the extra amount you can pay gets bigger as you eliminate smaller balances and move on to the bigger bills.
The snowball method is a debt payoff plan that relies on the power of motivation. By focusing on your smallest debt first, you can pay it off quickly and see a fast win.
You get a sense of achievement, which can motivate you to keep going.
Pay Off Debt Using the Avalanche Method
The avalanche strategy is based on making the bigger payment on the bill with the highest interest rate until it is gone.
The debt avalanche method is most often used with high-interest credit card debt. Because credit cards tend to have high interest rates and low minimum payment amounts, paying them off can be difficult.
This is a popular debt repayment strategy because you save the most money in the long run by eliminating the highest interest rates first.
Pay Off Debt Through Consolidation
Instead of paying down several bills at once, you can choose to take out one loan and pay off all the other debts with the money. Then, you have one bill to put the big payment on.
People choose this method if the consolidation loan has a lower interest rate than their existing loans. It also simplifies bill paying.
Debt consolidation can also help you get out of debt faster. Notably, you’ll have a strict timeline for paying off debt, unlike credit cards that let you charge until you’ve reached their limit. Consolidation loans typically offer repayment terms of between 24 and 60 months.
Consolidation Loan Options
Rather than a personal consolidation loan, you could choose to consolidate all your credit card balances on one credit card with the lowest interest rate.
Some credit cards offer a zero or very low introductory interest rate for a specified length of time. The length of time the low interest rate is applied is usually just 12 to 18 months or less.
Additionally, if you own your home, you can consider getting a home equity loan. Here, you get money from the value of your house to pay bills now. So, you can consolidate the bills under the single home equity loan. You will still have to make your mortgage payments.
It’s important to know that any loan you take in home equity will be paid back in full when you sell your home. Depending on the circumstances, you may not receive much of the home’s sale price if you’ve used that investment to pay your credit card bill.
Carefully Consider Using a 401(k) Loan
Your 401(k) fund is an employer-sponsored retirement fund. If you take out a 401(k) loan, you are essentially borrowing money from yourself.
If your plan allows it, you can borrow up to 50% of your 401(k) balance or $50,000, whichever is less. Then,you’ll have up to five years to repay the loan. If you don’t pay the loan back within five years, the IRS will count the borrowed money as a distribution. The result will be that you’ll owe income tax on the amount that has not yet been repaid. Additionally, if you are under 59 1/2, you will also owe a 10% early withdrawal penalty.
Critically, if you separate from your employer for any reason, you might have to repay the full loan balance right away or risk paying the withdrawal penalty.
Combine Methods for Your Personal Plan
If you are eligible for a no-interest credit card, then transfer balances from high-interest cards to save money. Then, put the total amount of all the payments you’d normally pay on the credit cards on that single card.
Don’t make the mistake of paying just the required minimum on the new card. By the time the interest rate on the new card goes up – and it will, after the introductory period – you’ll be back at square one, with a big bill to pay at a high interest rate.
If your debt is in school, car, and/or other non-card debt, the personal consolidation loan is a better choice.
The views expressed in this article are not personal advice. You should contact a qualified, and ideally regulated, adviser to obtain up-to-date personal advice regarding your own personal circumstances. If you do not, then you are acting under your own authority and deemed “execution only”. The author does not accept any liability for people acting without personalised advice, who base a decision on views expressed in this generic article. This article reflects the legislation current at the time of writing. New legislation is rarely added to existing articles. Please check for later articles or changes in legislation on official government websites.
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