Dear Ask Bankable:
What is the best way to pay off debt?
Money Master says:
Amid an improving economy and rock-bottom interest rates, Americans have been financing big-ticket items and smaller purchases left and right. Eight in ten people have racked up some kind of debt, according to Pew Charitable Trusts. Credit card debt has cracked a ten-year high at $1 trillion; more than 40 million people have student loans; and the average household with a car loan owes over $27,000, according to NerdWallet.
Yet, the overwhelming majority of people would prefer to be debt free, says Pew. So, it’s no surprise that reducing or eliminating debt is the No. 1 financial priority that Americans have, according to a surveyby BMO Wealth Management.
To make a plan of attack for getting out of debt, start by making a list of all your loans, including their balance, minimum payment and interest rate. Be sure to pay at least the minimum amount due on all your loans to avoid fees and interest – or worse yet, collections attempts and damage to your credit score.
From there, there are two schools of thought on which loans to throw leftover cash at. The debt avalanche method makes the most financial sense. It calls for you to throw any leftover cash at the loan with the highest interest rate. (This is probably your credit card debt, where the average interest rate sits at 16%). When you’ve polished off your highest-rate loan, you move onto your next highest-rate loan. This way you’re not paying more in interest than you have to.
However, there’s another plan called the debt snowball method that was popularized by personal finance guru Dave Ramsey. It also calls for you to pay the minimum monthly payment on all your loans but then advises you to prioritize the loan with the smallest balance. When that loan is paid off, you move on to the next smallest loan and so on.
This method prioritizes the psychological boost you get from polishing off loans quickly: “The theory behind this is that it will give you confidence and get you excited about having conquered at least one debt,” says Elizabeth Buffardi, a financial planner at Oak Brook, Illinois-based Crescendo Financial Planners. While you will end up paying more interest over the long run, it’s the better choice if it will help you keep your momentum. A study by Northwestern’s Kellogg School of Management found that people are more likely to get out of debt if they focus on paying off credit cards with the smallest balances.
You should also seek to reduce the interest rates on your loans. Check and see if you could refinance your mortgage, auto loan or student loans. Call your credit card issuer and ask if they’ll give you a lower rate (reference your history of making payments on time, plus any raises you’ve gotten recently). You can also consider consolidating your credit card debt, either with a balance transfer card (the Discover It and Citi Simplicity both boast an 18-month, zero-interest promotional period) or a personal loan (check if you qualify for a lower rate at lenders like Upstart and Prosper).