You’re probably ready to be debt-free. You’re tired of debt looming over your financial health and you’re ready to experience financial freedom. Don’t worry, you’re not on this journey alone. How to pay off debt can seem like a daunting task but taking the initiative now will alleviate more debt later on. Reducing debt is one of the best actions to take for financial security. We’ll cover what the impacts of debt can have on your credit score and different approaches you can take to start paying off your debt.
First, let’s take a look at the impact debt has on your credit score. There are two types of debt - revolving and installment.
Revolving debt is common with credit card usage and comes from carrying over a credit card balance month to month.
Installment debt comes from personal loans, student loans, car payments, and mortgages.
Having debt doesn’t automatically mean you’re a high-risk borrower. However, amounts owed on accounts can determine 30% of your FICO score. FICO research shows that higher levels of debt can predict your ability to pay all your monthly obligations on time.
There are five factors in the Amounts Owed category that FICO takes into account.
According to a NerdWallet survey of 2.076 adults in 2019, the average credit card debt was $7,104. The average amount of interest a household will pay is estimated to be $1,162. Credit card debt is one of the costliest kinds of debt.
Now is the time to get serious on paying off your credit card debt. The first thing you’ll need to do is commit to paying off the minimum balance for each credit card. If you’re able to pay more than the minimum balance, go ahead. Paying off more the minimum balance will help speed up the process.
You may have a few credit cards with different APR rates. A great option to consider is a balance transfer card so you can move existing debt on a higher-interest rate credit card to a lower-interest-rate credit card. This doesn’t eliminate the debt but it allows you to save on the interest rate and helps you pay off your debt faster.
You can apply for a balance transfer when you apply for a new credit card. Most issuers won’t let you transfer a balance from another card of the same bank. Yes, this applies to personal and business credit cards. Banks typically don’t allow you to transfer balances between cards because they benefit from the interest rates you pay when you carry a balance.
If this option interests you, just be aware that there may be a fee to make a balance transfer. Most cards charge 3%-5% of the balance you want to transfer (or $5-$10, whichever is greater). You can try to look for a credit card that offers a $0 balance transfer fee for a certain time or waives the fee altogether.
The answer is it depends. The issuer will determine the amount you can transfer over. Talk to your issuer about what your options are. Issuers like to see at least a 690 credit score in order to consider a transfer. Don’t be discouraged if you’re not able to transfer your credit card debt to a lower-interest-rate credit card, you still have other options. You can still make multiple payments every month to make progress on your credit card debt.
You may be ready to commit to paying off your debt and want to know where to start. The first approach we’ll take a look at is the debt snowball method.
Picture a small snowball starting out on top of a hill. As it rolls down, it gains more momentum and begins picking up more snow to grow larger and faster. This is the theory applied to the debt snowball method.
The approach was made popular by personal finance expert, Dave Ramsey. The idea is to focus on paying off your smallest debt first while making minimum payments on the rest of your debt. Once your smallest debt is paid off, you’ll apply the same amount you’ve been contributing to your next smallest debt, hence, the snowball effect. You keep repeating this cycle until your debt is paid off and you get to yell, “I’m debt-free!”
The approach is based on behavior modification. It allows you to examine your finances and start taking action to pay off your debt. Paying off the smallest debt first provides you with the motivation to keep going. Once you see your first debt get eliminated, you’ll gain more confidence that being debt-free is attainable.
Start off by listing your debt from smallest to largest balance, regardless of interest rates. This includes credit cards, student loans, and auto loan payments. Mortgages are excluded in this exercise.
Begin making the minimum payments on all your debt except for the smallest
Pay as much as you can on your smallest debt.
Repeat this process until each debt is paid in full. It’s important to note that once you pay off your smallest debt, you’ll continue to contribute the same amount towards your next debt.
Many people have experienced success with this method because it motivates them to see the smaller debts get eliminated. People are more motivated by progress than anything else. However, this may not be the best method if you want to be conscious of the amount of interest you end up paying.
Another method you can consider is the debt avalanche approach. Instead of listing your debt balance from smallest to largest, you’ll list your debt from the highest interest rate to lowest interest rate. The idea is to pay off the debt with the most expensive interest rate. This method will save you more money than the debt snowball method yet the principals are still similar. You’ll still make the minimum payment on each balance but you’ll prioritize paying extra on the debt with the highest interest rates.
Lenders and credit card companies tend to collect interest on top of the principal loan balance you’re borrowing. This method attacks the highest interest rates first so you can stop the growth of compound interest rates.
The downside of the avalanche method is it may feel overwhelming to pay off your high-interest rate debt first.
List all of your debt balances ranging from highest to lowest interest rate.
Create a budget and figure out what you’ll need to move around in order to pay the minimum balance for each debt account. Decide how much extra contribution you can make towards your debt.
Pay off the minimum balance on all your accounts and make additional contributions to the debt with the highest interest rate.
Repeat this process until all your debts are paid.
The debt avalanche approach takes a mathematical approach towards your debt and it’ll save you more in the long run.
If you’ve made it this far in the article, you’re probably curious about other ways you can save money while you pay off your debt. You can consider renegotiating the interest rate on your loan or credit card. This requires lenders to change the terms of your agreement so you have to strategically approach this option.
Request a copy of your credit report. All the major credit bureaus are required by law to provide consumers with one free copy of their credit report annually. You’ll have more negotiation power if your credit score is higher. Go back and read through your loan agreement again to remind yourself of the terms and conditions. This will help you in the next step of the process which is to shop around. Reach out to the competitors of your credit card or loan companies and receive interest rate quotes from them. The quotes will give you leverage when it’s time to negotiate with your current lender.
Lenders have their own policies so when it comes time to contact them, ask for someone who has the authority to lower your interest rates.
The last approach we’re going to discuss is withdrawing from your 401(k). A 401(k) is a retirement savings account sponsored by an employer that allows you to contribute a portion of your salary into a long-term investment. Your employer may match your contributions to a certain amount. It allows you to save and invest portions of your paycheck before taxes are taken out. Taxes won’t be paid until you withdraw from the account.
You could find yourself in a place where you’ll need to withdraw from your 401(k) early. Usually, a triggering event will need to occur in order to receive your payout. The triggering event includes:
If you no longer work for the company that sponsored your 401(k) plan, you can contact your 401(k) administrator and ask them how to take money out of the plan. You can no longer borrow your money in the form of a 401(k) loan or take a hardship withdrawal but you can take a distribution or roll your 401(k) into an IRA.
Any money taken out of your 401(k) plan falls into three categories with different tax rules. If you are no longer working for your employer and you’re over the age of 59 1/2, you qualify for a regular 401(k) withdrawal. You’ll simply pay income tax on the amount you take out but there will be no penalty due to age.
Most people fall within the early withdrawal category. This applies if you’re not 59 1/2 yet. One thing you need to be aware of is you’ll pay income tax on the amount you withdraw and a 10% penalty.
Lastly, you have the option to do a rollover of your 401(k) account balance to an IRA company of your choice. You don’t need to pay taxes to do a rollover and your money can stay in your IRA for later use.
Some 401(k) plans will not let you take money out of your plan while you’re still employed but there are some plans that offer a few options. You can choose to do a hardship withdrawal or in-service distribution.
A hardship withdrawal is not an easy process. It’s often difficult to get and costly if you receive it. Your 401(k) is meant to be a retirement savings account and it should be the last resort for cash. Employers use two methods to determine hardship eligibility. The first method is asking for proof of need. Most employers don’t use this method because it requires receiving detailed financial information from you. The second method is self-certification which doesn’t require you to disclose your financial information but you’ll be limited in making your 401(k) contributions for six months.
Paying off your debt won’t be an easy task but it’ll be worth it. You’ll be closer to achieving financial security and you’ll no longer have the looming stress of debt. Keep doing your research and make a plan on how you want to get started. The most important thing you can do is commit and don’t quit.