Americans held more than $4.3 trillion in debt as of July 2021, according to the Federal Reserve. There are tons of potential sources of debt for the average person, including mortgages, auto loan debt, student loan debt, credit card debt, medical debt, and tax debt.
If you have debt from multiple sources, you may be wondering where to begin paying it down. Should you choose based on the lender? The principal? The interest rate?
There’s no one right answer.
“The repayment strategy really depends on your personality and what will ensure that you stick to the plan,” says finance coach Maggie Germano. "You should use the repayment strategy that you know will be the most motivating to you."
“In the end, the most important thing is that you’re working to repay all of your debts,” FinanceBuzz writer Matt Miczulski agrees.
Here are some factors to consider when it comes to debt repayment:
Your starting point should be to ensure you consistently make the minimum monthly payment on each debt. Making the monthly minimum payment on each of your debts will keep you from racking up extra interest and fees that add on to the principal.
And making your minimum payments on time will not only keep your debt from growing; it will also improve your credit score.
Then, put as much additional money as you can toward the monthly payment of one debt at a time. Once that debt is repaid, start on the next.
If you’re having trouble making the minimum monthly payments on your debts, consider using the services of one of the top debt relief companies. A debt relief company can provide solutions including debt consolidation and debt settlement.
For some debts, the interest rate may change over time. For example, you might have a loan with a variable interest rate, or a credit card with an introductory interest rate. In those cases, you'll want to pay down the principal while you can take advantage of lower interest rates — especially in the case of credit cards.
"That is because once that (introductory) period ends, the interest rate is going to skyrocket, and a lot of the time, the interest will be retroactively applied, so it will be a large sum," Germano says.
When you decide which debt to focus on repaying first, take into account any changes in interest rates that may be coming up.
The debt avalanche refers to a popular strategy where you pay off debt starting with the loan that has the highest interest rate.
The thinking behind this strategy is that the higher the interest rate, the more money the debt costs over time. Tackling high interest debt first, such as credit card debt, should save you money, no matter your financial situation.
"High interest rates on credit cards can be debilitating as they make your balances get bigger and bigger," Germano says. "Plus, you're more likely to be able to defer something like student loan payments if you are going through hard times. Credit card companies usually aren't as understanding."
Consider the difference the interest rate can make in paying off a $10,000 debt. If you have a student loan of $10,000 that you borrowed at a rate of 3.25 percent, it will cost you more than $2,600 in interest alone over 15 years. Paying off the same amount of money in credit card debt at an interest rate of 24.99 percent would cost you more than $7,600 in interest alone over only 5 years.
“If it’s important for you to save the most amount of money in the end, focus on paying off your most costly debts first,” says Miczulski. “While it might take longer to tackle each debt, it will save you the most money in the long run.”
The debt snowball refers to a strategy where you pay off debt starting with the smallest debt.
Financial coach Dave Ramsey is a big proponent of this strategy. The idea is that even though you save more money by paying off debts with the highest interest rate first, starting small helps you gain momentum and build motivation by eliminating debts quickly.
"If you're someone who needs to see progress and who benefits from celebrating small wins frequently, the snowball method is probably the best repayment strategy," Germano says. "That's because this method allows you to meet smaller goals sooner and more often than big goals."
Miczulski started out with the debt snowball when he was saving for his wedding.
"It felt so good that I knew I could start chipping away at my most expensive debt and, while it would take longer to pay off, I knew I’d stay motivated until I saw it though," Miczulski explains.
There's no one-size-fits-all approach to paying off debt. What worked for your neighbor or accountant or the finance blogger you follow might not work for you.
Maybe you, like Miczulski, will start out with one strategy and then shift to another. Or maybe you'll use a combination of several strategies.
Just remember that if the goal is to get out of debt, then whatever method works for you is the right one.
July 22nd, 2022
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