Borrowing is part of life. It’s challenging to own everything you need at every point in time, hence the need to borrow to meet specific expenses. According to reports in 2017, the average American carries credit card debts of over $6,000 and mortgage debt of over $20,000. There are also large amounts of student loans and other loan types.
Debt can be a significant limitation to financial growth and a cause of worry. When an individual has accumulated a lot of debts, whether, in the form of credit cards or loans, they will have less and less money to spend at the end of every month.
This makes debt reduction an essential aspect of living. For most, becoming debt-free is vital to living a stress-free life and achieve financial independence. But how do you become debt-free?
Debt Reduction Methods
There are several ways to get out of debt. It’s up to you to decide which is best for you. Below are some of the popular debt reduction methods.
Snowball Method
The debt snowball is a concept recommended by financial advisor Dave Ramsey. The debt reduction method requires that you throw in every spare penny you have towards paying off your smallest debt, regardless of the interest rate.
The idea is to provide a psychological boost to continue making your payments. When people pay off a particular debt, they feel excited by the success and are motivated to continue saving towards debt payment.
The method also has the advantage of increasing your credit score. Depending on the type of loan and whether the debt is reported to the bureau, every debt paid off reduces the number of accounts with outstanding balances and can boost your score.
How the Snowball method works
- Make a list of all your debts.
- Pay the minimum amount due to each debt monthly. This way, you won’t default on any loan.
- Identify the debt with the minimum amount amongst all your accounts.
- Put-in as many funds as you can spare to offset the loan
- Once the first debt has been cleared, you can then focus on the next smallest debt on your list, and the next until all loans are fully paid.
For example, if you have the following liabilities.
- Auto loan – $3,200 – 9% –
- Student loan – $1,500 -7%
- Credit card – $5,000 – 15%
- Mortgage – $9,200 – 11%
Following the snowball method, you have to first pay off the student loan since it has the least amount of $1,500. After that, the auto loan at $3,200 and then Credit card debt at $5,000 before mortgage at $9,000. Each debt you pay off provides you with extra money to offset the next one.
If you can pay a minimum of $500 towards the student loan for four months, you will clear off the loan, and then save the $500 you usually pay for it towards paying for your auto loan, which is the next smallest loan.
Why Use The Snowball Method?
- It’s perfect if you have a lot of small debts
- It motivates you to pay off your debt gradually.
- It allows you to build your credit score gradually
- It’s straight forward and easy to implement
Downsides of the snowball method
- You may end up paying more than you are saving by paying off the debt. The interest amount from the outstanding loans can be higher than what you will save from paying off the smallest loan.
- It will take longer to pay off large loans fully.
Debt Stacking
This is also known as the avalanche method. It’s quite similar to the snowball method; however, the loan payment is based on interest rate rather than amount. People are drawn to this method because it’s focused on lowering your liability while making your repayment.
For instance, if you have several debts, the idea is to first pay off the one with a higher interest rate.
Successful paying off an account frees more money to put into other loans. It may, however, take some time to be able to pay off each loan, especially if the loan with the highest interest rate is also large.
How it works
- First, make a list of all your debts
- Arrange the debts based on the percentage of interest you pay on each.
- Pay the minimum repayment amount due for each debt every month.
- Identify the debts with the largest interest rate, and put any extra money to pay it off
- After paying off the first debt with the largest interest rate, move to the next, and so on.
For example: if you have the following liabilities.
- Auto loan – $3,200 – 9% –
- Student loan – $1,500 -7%
- Credit card – $5,000 – 15%
- Mortgage – $9,200 – 11%
The Stacking method recommends paying off the credit card debt of $5,000 with 15% interest, as it has the highest rate. After that, you then move to pay off the mortgage $9,200 with 11% interest. Once the credit card is paid off, channel the money for it towards your mortgage to fasten the repayment.
Why Use The Debt Stacking method?
- It allows you to save more. When you pay off a debt with a higher interest rate, your monthly repayment amount is reduced.
- It improves your credit score.
Downsides of Debt stacking
- It may take you longer to pay off your debt
- There’s no immediate psychological boost to spur you to make more payments.
The Hybrid Approach
The hybrid approach is in-between the snowball and debt stacking method. It recommends paying off the most annoying debts first. We all have that one debt that annoys you every time you think about it. Clearing that debt will bring you so much relieve and give you a psychological boost. The annoying debts are usually those with the highest interest rate.
Steps To The Hybrid Method
- Make a list of all your debts and the respective interest rates
- Arrange the debts based on their interest rates. From the highest to the lowest.
- Take the debt with the lowest amount and place it at the top.
- Make payment for the first debt (the lowest amount)
- Make payment for the next debt with the highest interest rate.
So if you have the following liabilities.
- Auto loan – $3,200 – 9%
- Student loan – $1,500 -7%
- Credit card – $5,000 – 15%
- Mortgage – $9,200 – 11%
Your payment will be in this order
- Student loan – $1,500 -7%
- Credit card – $5,000 – 15%
- Mortgage – $9,200 – 11%
- Auto loan – $3,200 – 9%
First, you will work to pay off the student loan, and after that, channel the money saved to pay credit card debts, before mortgage and auto loan.
Debt Reduction tools
There are various tools and strategies you can adopt to clear your debt, including the following:
Refinancing
By refinancing debt, you can significantly reduce the interest rate to allow you to pay it off quickly. Refinancing involves getting another loan with a lower interest rate to pay off your existing loan. So you will be making payment for the new loan. For instance, if you have a mortgage balance of $7,000 with a 9% interest rate. You can refinance it with your current lender or a new lender to about 5%, saving you a 4% monthly interest payment.
The same can be done to credit card debts, auto loans, and other sorts of loans. However, it’s not always a good idea to refinance your debt. There are times when refinancing can be more expensive than actually paying off your current debt. So it’s essential to compare the amount you will save from interest by refinancing your current payment before making a decision.
Another issue about refinancing is that it can increase the length of your loan. For instance, if you only have about five years left to pay in your current mortgage, refinancing it may increase the repayment period to more than five years.
Home Equity
If you have made considerable payment to your mortgage, you can take out a mortgage equity loan and use the proceeds to pay off your debts.
Home equity loans are quite different from consumer loans and usually come with lower interest rates. When you take this type of loan, you aren’t refinancing your current mortgage; rather, you are taking a smaller loan on the equity you have on the mortgage.
For instance, If you have paid $10,000 on your current mortgage, you can take a mortgage equity loan on your mortgage payment to pay off smaller debts like credit card debts or medical bills. However, you first have to qualify for a cash-out loan refinance.
If you take out a loan with a long repayment period, you may also end up paying more for interest. There are also fees associated with this loan; hence, it is important to consider all these before taking it.
Balance Transfer
Balance transfer is a major tool that comes handy to pay off credit card debt quickly. It allows you to merge debts from various cards into one to ease the repayment. Typically, the idea is to transfer debt from high-interest credit cards to one with a lower interest rate. So, in other words, you will be paying lower interest rates in total, while gradually paying off the loan.
Most credit cards come with as zero APR for the first few months and provide an excellent opportunity for you to pay off your debt without incurring any form of interest.
For instance, If you owe $5,000 with14% interest on one card, you can get a credit card with a 0% rate and transfer the $5,000 balance from your current credit card to it. You won’t have to pay interest for that period, and can rather channel the funds into making your repayments. With a monthly payment of $800, you can pay off the loan in 7 months before the introductory period elapses.
Most credit card companies, however, require a balance transfer fee. So it’s essential to run the numbers to ensure the fee doesn’t exceed the interest you will save. Alternatively, you can find a 0% credit card with no interest rate.
Good Debt And Bad Debt
Debts are of two types’ good debts and bad debts. When making a borrowing decision, it’s essential to ask yourself the category that specific debt falls into. Is it good debt or bad debt?
Good debts are low-interest debts. For instance, home equity loans are good debt because it comes with lower rates. Good debts can also simply be investments that will yield future gains. For example, a student loan will boost your profile and increase future earning potential. Taking out a mortgage or auto loan is also good debt, as you are investing in a home or car.
Bad debts, on the other hand, are debts that carry high-interest rates like payday loans and cash advances. It can also be debts taken to purchase things that lose their value very quickly. For instance, taking a $150 loan to buy a designer shirt that will run out of style in months is a bad investment.
Ways to Get Out of Debt Faster
Pay more than the debt minimum
This is the basis of all three methods we mentioned. Paying more than the required minimum each month will not only allow you to make payments faster but will also save you money on interest. Most lenders, however, charge early repayment fees.
Earn more
The surest way to pay your debt faster is to increase your earning. When you earn more, you will have more to save and channel towards your debt. You can take up a side hustle in addition to your day job. For instance, you can freelance, deliver food, goods, and groceries, or get a part-time job. Other side hustles you can take up include coaching, online tutoring, ride-sharing, and more.
Control Your Spending
Create a budget and adhere strictly to it. Remove or reduce unnecessary spending to have more to save. For instance, you can consider reducing the amount you spend eating out at the restaurant.
Conclusion
Debt is a significant part of life for most Americans. However, being able to pay off your debt and become debt-free is an amazing feeling. Depending on your financial situation, you can follow any of the listed methods to clear your debt.