Back to Basics: 3 Ways to Pay Down Debt

Back to Basics: 3 Ways to Pay Down Debt

Back to Basics: 3 Ways to Pay Down Debt

What comes to mind when you think of debt?

Maybe it’s your education, your home, or your vehicle. Some of the most important things in our lives are results of current or former debt, and we sometimes use it to help ourselves, our families, and our friends in crucial moments. Debt can help us take the next step forward — or make us feel like we’ve fallen two steps behind.

Types of debt

Since it tends to take on a negative connotation, let me start by making one thing clear: Not all debt is bad debt. Take, for example, your home. If you live in Fort Collins, you may know home prices are still on the rise, and homes tend to appreciate in value. Your home is an equity-builder, and taking on debt to invest in a primary residence is an example of good debt — provided the level is manageable. The same goes for investment properties: Investing in a home to rent out and generate income can be very positive if the amount owed is reasonable. In short, property builds your net worth. And taking on this “good” debt, at least initially, is the way most people acquire real property and businesses.

Even debt often considered “bad” can help us get ahead in life. Student loans allow us to attend college, graduate, get jobs, and make our way through our careers, often allowing us to earn more over our lifetimes. Car loans help us purchase vehicles so we can more easily navigate our day-to-day lives, saving us time. And, as they say, time is money. Still, even these debts can feel like a major burden.

And then we get to other types of debt like medical and credit card. You may be healthy today but have medical debt to go along with it that you’d like to pay off. Or maybe you and your credit card just had a little too much fun last month and it’s looking like you’ll only be able to pay off a portion of the bill … or you’ve been swiping freely for the last few months and are starting to feel like you’re losing control of your spending.

No matter the type you’re dealing with or how you incurred it, it’s important to know you’re not alone.

Let’s do the numbers

Debt may even be more common than you realize. In fact:

  • Student loan debt in the U.S. alone has reached $1.6 trillion — that’s trillion with a “t.”
  • Credit card debt in the U.S. adds up to $423.8 billion.
  • The average household has $135,065 in debt.
  • Household debt from mortgages, auto loans, student loans, and credit card debt totals $13.51 trillion.
  • Not counting mortgages, consumer debt reached $4.052 trillion in March 2019.
  • Auto loan debt hit $1.161 trillion a few months ago, and delinquencies are increasing.

With these numbers on the rise, there’s no better time to start working your way to financial freedom than right now. And no matter the type of debt you have or how you accumulated it, there’s likely a paydown method available to suit your style. Not only can paying down debt make you feel better about your financial situation but choosing the way in which to do it can also give you the push you need to begin — and follow through. But where can you start, exactly? By making a commitment to limit incurring further debt as much as possible. Then, it’s time to drive the numbers down.

Let’s go back to basics on paying off debt.

3 debt-payoff methods

If you’re serious about planning your way out of your debt, you have many choices. These are three of the most popular strategies:

1. Take the avalanche approach.

This means putting extra funds toward your debt with the highest interest rate first. This slow start might make it seem like you’re not making much progress, especially at first. After time, though, you’ll begin gaining so much momentum that, like an avalanche, there could be no stopping you!

Credit cards can be a strong starting point for an “avalanche” payoff since they tend to have the highest interest rates for borrowing. For example, consider the following:

  • $7,500 on credit cards at 19.4%
  • $21,000 in student loans at 4.5%
  • $275,000 mortgage at 3.5%
  • $5,600 car loan at 4.2%

According to the avalanche method, a borrower with these loans at these rates would begin by putting extra money toward credit card debt as it has the highest interest rate. It might seem counterintuitive to pay off student loans next rather than start working on the car loan balance. After all, a lender could repossess a vehicle but not your education. But by paying down the highest-interest-rate loans first, borrowers pay less in interest over time as compared to other methods. With the car loan paid, this borrower would then move onto her “good” debt —  the mortgage — unless something else with a higher interest rate had come up along the way.

While the avalanche method may make the most sense given the savings in interest charges and the opportunity to be out of debt most quickly, it’s not the most motivational method.

2. Give debt the snowball effect.

With the snowball effect, you get the ball rolling quickly by paying off your smallest amounts owed first. By starting small, you can build confidence more quickly as you take debts off your to-do list. This can encourage you to keep going as the number of loans dwindles more quickly and you begin to pay down larger balances.

Let’s consider the same example figures as we did for the avalanche method:

  • $7,500 on credit cards at 19.4%
  • $21,000 in student loans at 4.5%
  • $275,000 mortgage at 3.5%
  • $5,600 car loan at 4.2%

With the snowball approach, the borrower would begin by paying down her car loan since it’s her lowest debt by amount at $5,600. Being the easiest to pay back based on this dollar amount, it would also be the fastest to tackle. She would then move on to her $7,500 in credit card debt, followed by her student loans. Like the avalanche method, her “good” mortgage debt would be the last figure to pay down. Sure, she would pay more in interest on her credit card debt by paying only the minimum while she focused extra funds on her car loan. But the satisfaction of seeing her progress — being down to only three loans so fast — could really start the snowball rolling. That momentum could be the strong motivation she needs to keep going until she can rid herself of debt.

3. Chip away at the debt iceberg.

A third paydown method is starting big — in terms of balances, that is. The downside: Paying down a large debt first can be a long process while others remain. It might not feel like you’re accomplishing much on the surface but, when you take care of that last payment, getting “the big one” off your balance sheet can feel like a major win.

Using the same figures we’ve looked at in the last two examples, let’s see what the iceberg method could do — but with a twist:

  • $7,500 on credit cards at 19.4%
  • $21,000 in student loans at 4.5%
  • $275,000 mortgage at 3.5%
  • $5,600 car loan at 4.2%

In the most straightforward version of the iceberg approach, the borrower would start chipping away at her mortgage first. However, with such a low interest rate — and considering that this is her “best” debt — it wouldn’t make much sense at all in the long run. This is true for two reasons: Interest would be building rapidly on her other debts and her credit score could even be shrinking at the same time. Hence the modified iceberg approach: Paying down the not-as-good debts first, beginning with the largest balance. Mortgage aside, she would start with her student loans, then move on to credit cards, and finish her repayment process with her car loan. After that, she would move on to her mortgage.

Reminders

Remember that these are only some of the ways you can work your way toward being debt-free, and you may find another method entirely works better for you. Once you’ve chosen the option that best meets your needs, it’s time to get started! Just take it one step — or billing cycle — at a time, and be careful not to get so aggressive in attacking your debt that you cut yourself short elsewhere in your budget.

Of course, paying the minimum on all statements is a must-do throughout the process to avoid as many additional fees and charges as possible. Your paydown bonus: A higher credit score!

Once you’re debt-free — or, better yet, while you’re paying your debts down — avoid getting stuck in that situation again by building your emergency fund and sticking to your budget.

If you have debt paydown or other financial planning questions, just ask!

Interested in meeting to plan the path to your financial future? You can start by taking a look at the How It Works page to learn more. Then, simply schedule a time for a no-cost web or in-person financial planning consultation.

Jason Speciner
jason@fpfoco.com

Jason Speciner is a CERTIFIED FINANCIAL PLANNER™ professional, an Enrolled Agent, and the founder of Financial Planning Fort Collins, a 100% employee-owned and fee-only firm. He is also a member of the National Association of Personal Financial Advisors (NAPFA) and XY Planning Network (XYPN). Since 2004, he has served clients of all ages and backgrounds with unique experience working with members of generations X and Y. To learn more, check out Jason's blogs and see the media he's been featured in.



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