Effectively Paying off Debt

??????????????? In the past few years, inflation has skyrocketed, and so has the cost of… well… everything. Especially when the growth of wages continues to fall behind, debt for many Americans is almost inevitable. In fact, here’s a breakdown of the average amount of debt held by Americans by generation provided by USA Today, with the average amount of debt held as of the Q3 2022 being over $100,000.

Debt can be a very intimidating thing, especially when so many very young people are immediately starting their adult lives with more and more student loans. In this article, we help break down some ways you can manage your debt and pay it off in a way that makes it seem a little less daunting.

List Your Debts & Desired Additional Payment

??????????????? The first step in managing your debt is to list down every type of debt that you have, including the name of the account, the type, the current balance, interest rate, minimum payments, and the term (how long the loan lasts for). Some examples include student loans, car loans, credit cards, HELOCs, and mortgages. From there, you can order them based on balance or interest rate, depending on which is more important to you. It makes it easier to set goals when you have them written out in front of you.

??????????????? From there, it’s important to decide with what level of aggression you’d like to pay your debt off. Do you want to sacrifice luxuries now in exchange for paying your loans off as fast as you can? Would you rather maintain your luxuries and pay your loans off slower? Maybe you fit somewhere in between these two! This is a tough decision, because while it’s tough to make sacrifices in the short term, paying your loans off quicker will save you a lot of money and stress in the future. Make sure to evaluate your current budget so you can determine what’s best for you or contact a financial advisor if you have more specific questions. From there, it’s time to decide what method of paying off your debt makes the most sense for you both financially and psychologically.

The Avalanche Method

??????????????? The avalanche method targets the highest-interest loans first. On paper, this method typically makes the most sense, as it targets loans that accrue interest the quickest, and it saves you the most money. With this method, you pay your minimum payments on all your loans, and you add an additional amount, depending on your desired level of aggression, to the highest interest rate loan. Once you’re done paying off your first loan, you can take the same amount of extra money that you were putting towards the first loan each month to the next highest rate loan on your list! Over time, you’ll pay less and less as your interest and minimum payments will begin to disappear. However, doing it in this manner means that you could potentially be trying to pay off your biggest balance first, which can be difficult to do psychologically, especially if you already have debt racked up across multiple accounts. This can make completing that first step feel impossible, which can take a toll on you mentally.

The Snowball Method

??????????????? If you don’t care as much about being as financially efficient as possible and you’d rather have the psychological effect of breaking your debt down into more manageable chunks, then the snowball method may be better for you. It uses a similar approach to the previous method, paying the minimum payments on all your loans while trying to pay one off aggressively at a time. However, this method focuses on paying off your debts from smallest balance to largest instead of by interest rate. Once a loan is paid off, you put that same money into the next balance. Paying off a loan completely and quickly gets you excited and motivated early on to keep working hard to become debt-free. Sometimes, changing your behavior and getting in the headspace of small wins first makes tackling the larger debts much easier once you get to them, as you’re riding the momentum of success – kind of like a snowball rolling down a hill! It starts off small at first, but it quickly gets bigger and bigger, eventually carrying you to eliminate your debt!

Example

??????????????? I’ll introduce an example to get you acquainted with these methods. Let’s say you have 4 debts:

• $500 phone - $42 minimum payment – 6% interest
• $10,000 credit card debt - $200 minimum payment – 25% interest
• $5,000 car loan - $100 minimum payment – 7% interest
• $40,000 student loan - $150 – 8% interest

??????????????? In the avalanche method, you would pay the minimum payment of each loan monthly, totaling $462 per month. From there, you would allocate additional money, say $400, to the highest-interest loan: the credit card. You do this until you’ve paid off your credit card completely, then moving that extra $400 to the student loans. You’ve also knocked out that $200 minimum payment on the credit card. Following that, you have the minimum payments to make totaling $262 per month, as well as the additional $400 added onto your student loan bill each month until you pay THAT off. This method will save you the most money on interest, but it can be more difficult psychologically. Especially in this case, you’d be tackling your two largest debts first, which can make it feel like you’re not making much progress. This is where the snowball method can help.

??????????????? With the snowball method, you follow a very similar structure, except instead, you would start with the phone bill, then move onto the car loan, and so on. While you will be paying 25% interest on your credit card for longer, the momentum of having already paid two of your four debts off may help you feel more accomplished and excited to pay off your remaining debts. This is easier psychologically, even though you aren’t optimizing for saving money in the long term. Having 2 debts feels much more manageable than 4, making being debt free feel more realistic.

Conclusion

??????????????? These are just a couple ways in which you can make repaying your debts feel more manageable depending on what works for you and your financial situation. It's even possible to use a combination of these two methods so you aren't paying 25%+ in interest for longer than you absolutely have to. There are other solutions available, such as debt consolidation tools or balance transfers with credit cards with an introductory 0% APR to save you money in the short term. However, it is important that you understand every tool you use in its entirety, otherwise you could end up in a worse situation than before. If you don’t understand a tool or method, or if you have any questions, please contact a CPA or financial advisor before making any decisions, as this article is solely meant to provide general financial information. Good luck on your task of conquering your debt!