Today’s topic comes from Barbara, who says, “I have quite a bit of debt, including mortgages, prep school, and college for my kids that I worry about. What’s the best way to plan and pay off debt?”
I appreciate your question, Barbara! I know having a lot of debt can be stressful. This show will review wise strategies for creating a debt payoff plan that, hopefully, helps you worry less and eliminate debt faster.
What’s the best way to get out of debt?
Before I cover strategies to get out of debt, I want to review the differences between good and bad debt because that can help you know which ones to tackle first. Then we’ll review the debt payoff methods.
One way to know if a debt is good or bad is whether it pays for something likely to appreciate or depreciate. If you use debt to finance an asset that increases in value and boosts your net worth, it’s typically good. But going into debt for something that loses value or deflates your net worth is bad.
For instance, a home mortgage allows you to buy real estate that typically appreciates over the long term. While there’s no guarantee that a home will be worth more in the future, since the early 1990s, real estate has appreciated nearly 5% per year on average.
Another example of a good debt is an education loan. While a student loan isn’t backed by an asset, such as a home, it can help you earn more over your lifetime. A college degree is required for many jobs and industries, such as health care, law, and computer engineering. So, depending on the career you want, taking out a reasonable amount of education debt can boost your earning potential.
As I mentioned, bad debt finances something that loses value over time. Consumer debt like credit cards are one of the worst because they charge extremely high interest rates. Plus, they’re typically used for goods and services that have no value or depreciate, such as furniture, clothes, and vacations.
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What’s the best debt payoff method?
My first recommendation for Barbara is to make a list of all her debt, including the creditor name, interest rate, remaining balance, monthly payments, and any payoff dates. You might jot them down on paper, enter them in a Google sheet, or use my Personal Financial Statement (PFS) template, which is a free download when you subscribe to my free newsletter, The Money Stack.
There isn’t one secret for getting out of debt; however, the strategy you use can make a big difference in eliminating it faster. I also think having a debt payoff plan can reduce stress because you know exactly what you need to do to reach your financial goal.
You may have heard of a couple of popular debt payoff strategies, the debt avalanche and debt snowball. These high-level approaches can help you prioritize your efforts. We’ll review their pros and cons and some other strategies, so you can easily create a debt payoff plan that works for you.
What is a debt avalanche?
A debt avalanche is when you pay off debts from the highest to the lowest interest rate. You make minimum payments on all your outstanding accounts but put extra money toward your debt with the highest interest rate.
For instance, if you have a credit card balance of $10,000 at 23% and a $5,000 student loan at 6%, you’d tackle the card first. I really like this method because it’s the most cost-effective in the long run. By eliminating your highest-rate debts first, you save the most interest expense.
Plus, if you plow the savings back into your debt balance, you can reduce it faster. When you have a large amount of debt, tackling your highest rate debt first can be a wise method.
While a debt avalanche approach saves the most interest and time, the downside is that you must stay disciplined to regularly put extra cash into one debt, no matter its balance.
Sometimes, if your highest-rate debt is large, making extra payments on it may feel frustrating because you make slow progress. So, you need to stay motivated and remember that its high rate costs you the most interest on a percentage basis and is worth focusing on first.
What is a debt snowball?
A debt snowball is another high-level strategy when you pay off debts in order of the smallest to largest balances, no matter their interest rates. You make minimum payments on all your outstanding accounts but put extra money toward your debt with the smallest outstanding balance.
For instance, if you have a credit card balance of $10,000 at 23% and a $5,000 student loan at 6%, you’d tackle the student loan first. The idea is that you tackle the easiest debt first and anticipate a small win. That can motivate you to stay disciplined and eliminate your next largest debt, regardless of its interest rate.
The pro for a debt snowball approach is feeling like you make progress faster. It can be good when you have several small debt balances and want to wipe them out fairly quickly. But the downside is that you might pay more interest overall and take longer to become debt-free compared to a debt avalanche.
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What is debt consolidation?
Another debt payoff strategy is when you consolidate or combine multiple unsecured debts, such as medical bills, personal loans, or credit cards, to eliminate them faster. Debt consolidation shifts higher-interest debt to a lower- or no-interest account. While it may seem counterintuitive to use new debt to get out of old debt, paying as little in interest as possible helps you wipe it out faster.
Here are four ways you may be able to consolidate debt.
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Open a balance transfer credit card.
A balance transfer card allows you to move unsecured debt to a new or existing credit card with a 0% APR promotion that may last up to 18 months. It temporarily reduces the interest you pay, giving you some financial breathing room.
Once a transfer promotion ends, your interest rate increases and could be very high. Therefore, it works best when you’re sure you can pay off the entire balance before the promotion expires.
For instance, if you get approved to transfer $3,000 to a card charging 0% for 12 months, you could make monthly payments of at least 1/12 or $250, so it gets eliminated before your interest rate goes up.
Every transfer is subject to a fee, such as 3% or 4%, which gets added to your balance. However, avoiding interest during a balance transfer promotion can save a chunk of change, despite a transfer fee.
The amount you can transfer depends on the credit line the issuer offers. If you don’t have good credit, you may not get approved for a balance transfer or only be able to put a small amount of debt on a card.
ALSO LISTEN: Dealing with Debt: Expert Tips for Using a Balance Transfer Credit Card
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Take out a personal loan.
You can get a new fixed-rate personal loan to pay off higher-rate unsecured debt. You make monthly payments during a set repayment term, such as three or five years. The rate and terms depend on factors like your income and credit.
Remember that even though a personal loan may cut your interest, the shorter your repayment schedule, the higher your monthly payments will be. You risk hurting your credit if you can’t repay a personal loan as agreed.
You can enter basic information and see your loan options at sites like:
Consolidating debt is a good option when you have large balances to pay off and want a structured repayment term.
For example, if you have a credit card balance charging 23%, paying it off with a 9% fixed-rate personal loan over three years allows you to save a lot of interest over a set repayment schedule.
In addition, having a personal loan added to your credit history helps you build credit if you make payments on time. Doing a consolidation can also work in your favor by reducing your credit utilization ratio when you pay down credit card debt. So, a loan consolidation generally helps your credit and doesn’t hurt it over the long term.
ALSO LISTEN: How Consolidating Credit Card Debt Affects Your Credit Scores
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Take out a home equity line of credit (HELOC) or loan.
If you’re a homeowner with at least 20% equity, you may qualify for a HELOC or home equity loan. For example, if your home’s market value is $400,000 and your outstanding mortgage balance is $300,000, you have $100,000 in equity or 25% ($100,000 / $400,000 = 0.25).
A HELOC is a revolving line of credit with a variable interest rate that allows you to borrow an amount up to your credit line, using your home as collateral, without needing to refinance your existing mortgage. A home equity loan gives you a lump sum to repay over a set term, such as five to thirty years, with a fixed interest rate.
Since a HELOC and equity loan are secured debt, they typically charge lower interest rates than a personal loan. You can use them however you wish, such as for home renovations or paying off higher-rate debt.
However, if you use a HELOC or equity loan to buy, build, or improve your home, a portion of the interest paid is tax-deductible—but that’s not the case for other uses like debt consolidation.
The main downside of tapping your home equity with a HELOC or loan is that if you default, you risk losing your home to foreclosure. Plus, there are closing costs, similar to a primary mortgage, which add to the cost of borrowing. Consider getting multiple quotes, including from your current mortgage lender.
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Get a retirement plan loan.
If you have a workplace retirement account or are self-employed with a solo 401(k), most plans allow you to borrow from yourself with a five-year repayment term. Note that loans are never an option with IRA-based accounts, such as a traditional IRA, Roth IRA, or SEP-IRA.
While you must repay retirement loans with interest, it’s typically relatively low and goes back into your account. In addition, there’s no credit check, underwriting requirement, or fees since you borrow your own money. You can borrow up to 50% of your vested balance or $50,000, whichever is less.
You can use a 401(k) loan for any reason, including paying off high-interest debt. But remember that borrowed funds won’t get invested in the market during repayment, which could jeopardize your retirement.
Another consideration is that a retirement loan must be repaid in full within 60 days if you leave your job or get terminated. If you don’t repay it on time, the loan would be considered an early withdrawal, subject to income taxes plus a 10% penalty if you’re younger than 59.5.
Therefore, I only recommend consolidating debt with a retirement loan as a last resort, and If you’re certain you can repay it on time.
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Barbara, without knowing more about your financial situation, I’d lean toward a debt avalanche plan because you mentioned having large amounts of debt. And if you’re paying high interest rates on any accounts, doing one or more of the debt consolidation options that I reviewed may make sense.
Since mortgages have relatively low interest rates, they should always be paid off last.
Plus, a portion of your interest may be tax-deductible, costing you even less on an after-tax basis, provided you claim the deduction. In many cases, you can invest money for higher returns than you’d save by paying off a mortgage early.
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While I’ve reviewed popular debt elimination strategies, there isn’t a right or wrong way to pay off debt. Any method you can stick with and make steady progress will be a good one.