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Get Out of Debt…For Good

Jan 18, 2017 | 3 min read | Mina Black

 

You’ve probably been told, when it comes to debt, it’s best to avoid it altogether; and, if you happen to find yourself in debt, the best way to get rid of it is to pay it all off as quickly as possible.

While that approach makes sense mathematically, it’s definitely easier said than done.

According to a 2015 survey by The Pew Charitable Trust, 8 in 10 Americans have debt, with mortgage and credit card debt being the most common. The average mortgage balance was $130,000 in 2015, while the average credit card debt was $5,000. Auto debt averaged $14,000, while student loan debt added up to $20,000. You can see how easy it is to feel overwhelmed!

What do you do when you have debt and want to get rid of it, but aren’t quite sure how to tackle the problem? Here are two simple ways to consider paying off your debt.

 

Avalanche method: make a rational pay-off schedule

The avalanche method involves listing your debts from highest interest rate to lowest and making minimum payments on all debts except for the highest-rate debt. On that pricey balance, you’ll pay the minimum plus apply any extra money available. This method saves you the most money in the long run because you’ll pay off the most expensive debt soonest.

Let’s take a look at an example featuring monthly payments to four accounts:

Credit Card Balance Interest Rate Minimum Payment
Card One $500 26% $50
Card Two $2,500 18% $10
Card Three $1,000 15.07% $40
Card Four $1,000 12.82% $40

Using the avalanche method, you’d make the minimum payment on credit cards two, three and four. That amounts to $90. You would also pay $50 for credit card one ($140 total), plus any additional money leftover in your budget. If you had budgeted for $200 per month to pay off credit card debt, you’d be able to throw $110 at number one, thus reducing your balance to $390.

Let’s say you are able to apply $300 a month toward paying off the cards instead. The cards would be paid off in a little less than two years, and you would’ve paid a total of $849 in interest.

 

Snowball method: think small and grow

You may have heard of another approach to tackling debt: the snowball method. List all of your debts and order them from smallest balance to largest. Let’s repurpose our previous example as follows:

Credit Card Balance Interest Rate Minimum Payment
Card One $500 26% $50
Card Three $1,000 15.07% $40
Card Four $1,000 12.82% $40
Card Two $2,500 18% $10

You make minimum payments on all debts and pay extra toward the smallest balance. Once that’s paid off, you apply your surplus to the next smallest balance and so on. Keep doing this until you’ve paid off all your debt. Using this methodology, you’re motivated by the quick wins of paying off entirely a little debt (a line item), shrinking the size of your list (the number of debts) in advance of the overall amount you owe.

Using the snowball method, you would pay a little more interest ($1,057) but pay off all debt in a little less than two years too. You reduce the seeming size of your debt sooner with the snowball method because the first credit card would be paid off in as little as four months; whereas, with the avalanche method, your first debt wouldn’t be paid off until well over a year.

Research suggests that when you use either approach you’re more likely to get rid of all your debt than if you spread your money evenly across your various payments. However, with the snowball method, you can celebrate small achievements sooner, and that might help you cultivate a positive, winning feeling.

 

Set and achieve small goals

Whether you elect the avalanche (cheaper) or snowball (more gratifying) method of debt repayment, setting goals with regard to smaller amounts of debt (such as what is owed on each individual account) rather than thinking big picture, may help you cross the debt recovery finish line. Researchers at Northwestern University found we are more likely to reach a big goal if we break it up into small sub-goals. Think of it this way: if you have $5,000 in debt, paying off $5,000 seems like an overwhelming goal. But if you break it up into sub-goals – i.e. paying off $500, then $1,000, you’re more likely to complete the task of paying off the master sum, $5,000.

A study at Texas A&M University came to a similar conclusion. The researchers also found that the act of paying off the debts, especially when small, led to a greater likelihood of eliminating all outstanding debt. In fact, participants were 14% more likely to reach their ultimate goal of paying off total debt when they used the snowball method to pay off the smaller balances first.

 

Bottom Line

The next time you find yourself worrying about the mountain of debt you’ve accumulated and think “I’m never going to get out of this debt”, take a deep breath. Make yourself a chart and use one of these methods to simply, straightforwardly lift yourself out of debt by focusing on small achievable goals instead of an overwhelming balance. The answer to your money problems might only require a clear and disciplined commitment to a chosen course of action.

 

Consult your financial professional regarding your circumstances.

 

 

Mina Black is a mother to one, wife to one, and personal finance know-it-all to many.

 

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