calculatorHere are five different debt payoff strategies, spelled out in plain English, that will help you decide the right plan for you. Remember, these are simply options. Try one for a while, and if it doesn't work, go ahead and try another. Or, combine two different strategies! Make a plan that will work for you.
1. The Logical Method
How it Works: List all your debts, along with their interest rates. Pay the minimums on each one, except the one with the highest interest. Pay more than the minimum on the highest interest loan. Repeat once you've paid off the debt with the highest interest, then move on to the next highest interest, and repeat until you're finished. Luke Landes of Consumerism Commentary also calls this the "Debt Avalanche."
Pros: If the logical method is followed as written, it is the fastest way to get out of debt. Paying off the highest interest rate will absolutely save you more money, and it makes the most sense, empirically speaking.
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Cons: This method is very difficult to follow without some fatigue, and results are not often seen quickly. Pure math didn't get you into debt, and it's certainly not going to help get you out. Let's say you can only pay $100 after you've paid the minimums on all your loans. Now, let's say your highest interest loan is a credit card with 12% interest. But let's also say that the credit card's balance is $12,000. Adding an extra $100 a month will not make a remarkable difference in the way you feel. It's easy to give up when you feel like you're barely treading water.
Best for: People who inherited debt.
2. Liquidating 401(k) to Pay Down Debt
How it Works: Take a look at what you've saved for retirement. See what the penalties are if you take money out early. If there aren't any, or if the penalties are lower than your interest rates, then you can borrow from your future self to pay your current self.
Pros: Eliminates debt very quickly.
Cons: Losing the magic of compound interest. Paying taxes on money you're using simply to pay off a credit card. Starting over on your retirement savings. Losing any or all of the money you had earmarked for a much later day.
Best for: People who stand to inherit a small fortune or those who are otherwise "set" for retirement.
Not recommended for: Honestly, there are no scenarios (other than inheriting 7 figures later in life) where this makes sense. Debt should be hard to pay off, and if it's as easy as moving money (regardless of penalty) from one account to another, you're more likely to get right back in.
3. Debt Consolidation
How it Works: Talk to a credit counselor, or fill out an online application at the National Foundation for Credit Counseling. There, you'll lay out all of your debts, all your sources of income, and the counselor will consolidate your bills into a monthly payment you can afford at an interest rate that is (hopefully) reasonable.
Pros: If you're struggling to get ahead of your bills, and can hardly afford to make minimum payments, this might be the way to go. It gives you a repayment plan, an accountability partner, and most importantly, a get-out-of-debt date.
Cons: There are a lot of bad people out there who want to make money off the mistakes of others, so it is really important to find a company you can trust. There is less flexibility in consolidated debt, which can sometimes mean that you're stuck paying higher interest in the long run than if you hadn't consolidated. Paying down debt increases your credit score, and with a higher credit score, you can qualify for 0% interest balance transfers.
Best for: People who have a lot of debt and are ready to give up and declare bankruptcy, people who have a fixed income, people who want to get help, people who have tried everything, and people who have debt that they can't control themselves.
Not recommended for: People with less than $10,000 in debt, people who have some low interest debt, and people who want to be in control of every part of the payoff process.
4. The Debt Snowball
How it Works: This is Dave Ramsey's preferred method of paying off debt. He argues that we humans are motivated by quick wins, and we can build momentum when we list our debts in order of balance, and pay off the lowest balance first, ignoring interest rates. We go from being a person with debt spread across five credit cards to a person who has only four credit cards, and those quick wins give us strength to keep going, and pay off each one. So, pay the minimums on each of your debts, except the one with the lowest balance. Pay $100 more than the minimum there, and see how quickly one whole debt disappears! After you've paid off your lowest debt, add that payment to the minimum balance due on your next-lowest balance debt. So the idea is you're always paying the same amount, you're just allocating it differently. Hence the snowball.
Pros: It's highly motivating to eliminate debts one by one. You get on a roll very quickly. Debt repayment becomes a game. You stay energized. This method works for many hundreds of thousands of people.
Cons: Paying off your lowest balance doesn't take emotion into consideration. It's not mathematically the best way to pay off debt. You could be extending your debt free date by months, or even years.
Best for: People who have several debts across different categories. People who like to play games. People who enjoy marking things off a list!
Not recommended for: People who have emotional ties to some of their debts.
5. The Highest Shame Method
How it Works: List all your debts, along with their interest rates. In a third column, list how they make you feel. Your answer should either be neutral or ashamed. Did you write ashamed in more than one line? If so, rank the debts that made you feel ashamed from most ashamed to least ashamed. Ignore the neutrals for now. The debt that makes you feel most ashamed is your debt of highest pain. Pay this one off first. Do not pay attention to interest rates or balances. Pay attention to your feelings. Once you pay off all the debts that make you feel bad, you can focus on the neutrals and use either the logical method or the debt snowball to get those paid off.
Pros: This method will make you feel better about yourself and your situation almost immediately. We carry negative feelings about our debt, and those feelings have weight.
When I was paying off my debt, my internal dialogue kept saying, "only losers have credit card debt" over and over again. I couldn't shake it. All I wanted was to stop being a loser. I prioritized my 0% balance transfer credit card and paid that one first. The mathematics didn't matter. I swear, after the last credit card payment, I was a new woman.
Cons: This is a highly touchy feely way to get out of debt. It's definitely not for everyone. If you like numbers more than you like hugs, it's probably not for you. Or, if you tried this method, and every debt came back neutral, you'll need to use math or snowballs.
Best for: People who have "baggage" about one or more of their debts. People who have mean and negative internal dialogues. People who need more than just numbers to get motivated.
Not recommended for: Mathematicians.
-By Kathleen O'Malley
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