Many Americans struggle with paying down their high-interest debt, from student loans to personal loans and credit cards. Everyone seems to have different advice when it comes to the best way to pay off your outstanding debt. Each person’s situation is unique and requires a personalized approach. Ultimately, you should take the approach motivating you to act and make progress reducing your debt burden.
According to data gathered from the U.S. Census Bureau and the Federal Reserve, the average American household debt is around $5,700 and the average for balance-carrying households is $9,333. The total outstanding U.S. Consumer Debt is $3.9 trillion with $1.03 trillion of that as revolving debt. Add that to the total amount of student loan debt at $1.52 trillion and an average of $32,721 per borrower.
The first step of any debt repayment strategy is to make a list of all your debts including their current balances and interest rates, and whether the rates are fixed or variable. Then calculate your Debt-to-Income ratio by adding up all your current monthly debt payments (including mortgage or rent) and dividing that number by your gross monthly income. For example, if you make minimum payments of $200 to your credit card, $250 to your auto loan, $250 to your student loan, $800 to rent and you earn $6,000 / month, your debt-to-income ratio would be 25%.
Debt-to-Income Ratio = Monthly Debt Payments/Monthly Gross Income
= .25 or 25%
A debt-to-income ratio 20% or less is considered low while a ratio of 40% or more is a sign of financial stress. If your ratio is on the higher end of the spectrum, you may want to consult a nonprofit credit counseling agency to discuss credit card consolidation or debt relief options.
The next step is to isolate the high-interest rate debts like credit cards, student loans with rates higher than 6%, and variable rate loans. At this point, you may want to consider refinancing the high-interest rate student loans and variable rate loans to lower fixed rate loans. Keep in mind that you may lose some benefits if you refinance Federal student loans to a private lender. You should weigh the pros and cons of any decision to refinance. You may also be able to lower the rates on your credit cards through balance transfers or credit card consolidation. Be aware of any fees associated with these transfers as the cost will offset some of the potential savings.
After you have evaluated your debts and are unable to reduce your current interest rates any further, it is time to build your repayment plan. Start by ranking your outstanding debts by priority and determining how much extra money you can devote to debt repayment each month.
There are two common methods: The Debt Snowball and the Debt Avalanche. In the Debt Snowball method, you will prioritize additional payments to the lowest balance debts first. In the Debt Avalanche method, you prioritize additional payments to the highest interest rate debts first. In both methods, you continue paying the minimum to your other debts and as the current top priority debt gets paid off, you devote its previous monthly payment and extra money to your next priority debt.
The theory behind the Debt Snowball method is that you can get a small win up front. You can successfully pay off that first loan relatively quickly (because of the small balance) and direct more money to larger loans sooner. This can be motivational for some because the impact is seen more immediately. The Debt Avalanche method is more focused on reducing the amount of interest you pay in the long run. Because additional payments are going toward the higher interest rate debts first, you will ultimately pay less interest over the life of your loans than if you used the Debt Snowball method.
Regardless of the priority order you choose, the most important factor of any debt repayment plan is the process of allocating extra funds toward just one debt until it is paid off while paying the minimum payment on your other debts, then move on to the next priority debt on your list. Continue to do this until all your debts are paid off.
Lastly, rebuild your emergency savings. Aim to have at least 3 to 6 months of your monthly expenses in an emergency fund. Having an emergency fund is key in preventing you from going back into debt in the future.
You can be successful in paying down debt more quickly with a debt repayment strategy tailored to your specific situation. This process will help you take the first steps toward your new debt-free life.