Swimming In Debt? Here's How to Come Up With a Debt Repayment Strategy
Becoming debt free takes careful consideration and planning. In some cases, using the debt avalanche method, where you pay off the high interest debt, is your best bet to achieve financial security. Meanwhile, for other types of debt the debt snowball method, or paying off the debt with the lowest balances, will be the best approach. It's likely you'll use a combination of both depending on the types of debt you currently have.
If you have a lot of high-interest debt, then the debt avalanche method tends to be the way to go, as it can save you hundreds (if not thousands) of dollars in interest, whether you're paying off your student loans to buy a home or trying to reduce credit card debt. On the other hand, if you have several small balances such as credit cards or if you’re at the end of paying off a very large debt, then the debt snowball method will help you clear those debts as quickly as possible.
Things to Consider for Paying Off Debt Early
Not all creditors allow you to pay off a debt early without penalty. This is why it’s important to read the fine print on any loans or credit card contracts. It may seem odd that a creditor would want to “punish” someone for successfully paying off the debt early. But there are cases where it’s true and many times you need to ask that question directly (e.g. “Is there an early payment penalty if I pay this off early?”).
An additional consideration for paying down debt is your current financial condition. Do you have room in your monthly budget to pay off certain debts early? Do you have loans with high interest rates that are eating away at your income? Are there certain debts that will give you a tax break or other advantage in paying them off, such as having the ability to deduct the interest that you paid? What types of debt do you have? All of these things can stand in the way of building long-term wealth.
Credit cards, mortgages, auto loans, personal loans, and school loans all have different terms and conditions (with credit cards generally having the highest interest rates of all the debt classifications). The answers to these questions will help you to determine how feasible it is for you to use either the avalanche or snowball methods.
Using debt repayment calculators such as Credit Karma, Unbury.us, and Studentloanhero.com will help you determine how much you can save by paying off certain debts early and refinancing other student loans.
Investing vs. Paying Off Debt
Investing that extra money you’re using to pay off debt is an alternative to paying off the debt in the immediate future. It comes down to a choice between earning interest on your cash versus paying the creditor interest. However, if you have debt related to an essential asset, such as a mortgage, then securing your home debt-free will take precedence over all other debt. Collateralized loans, such as for homes and automobiles, mean the creditor can take those from you in the event you cannot make payments on the loan.
Additionally, if you have a student loan, this debt is not removed through bankruptcy. The U.S. government and its associated creditors will find a way to get their money back regardless of your financial situation. So it’s wise to pay this debt off as quickly as possible while also continuing to place even the smallest amounts of extra cash into savings, retirement or other investment accounts.
Take a close look at the return on your intended investment. If you’re just starting out in the world of investing, a less risky portfolio is often recommended. These tend to have a lower rate of return in terms of earning interest. Certain investments have tax advantages that can save you money and lower your tax liability. A wise move would be to speak with a professional financial advisor who can detail the pros and cons of investment versus early debt repayment.
Good Debt vs. Bad Debt
In our world of credit scores and big purchases that often require taking out a loan, there is such thing as good debt as long as it’s managed carefully. On-time payments for mortgages, auto loans, and school loans can boost your credit score. Also, investing in your education through school loans and purchasing assets that appreciate, such as a home, are debts that reap a rate of return, even if you have to buy a home with student loan debt. Essentially, they are investments. Real estate appreciates in value, and those with a college education tend to earn higher salaries when compared to non-college graduates.
Credit cards and purchasing things that do not appreciate in value (e.g. cars, clothes, other consumable items) are in the bad debt category. Though owning a car may be an essential part of living in certain areas of the U.S., cars depreciate in value. While you’re not exactly throwing money out the window, you're paying for an item that will be worth less than the loan amount you’ll ultimately pay. Learning how to maneuver through advanced budgeting techniques can help you determine what debt is worth assuming.
Ultimately, the decision to repay your debts early comes down to a primary variable: you (and possibly your partner). Research your options, use the recommended calculators (or others you may find on your own), and speak with tax and financial professionals to find the repayment and investment scenarios that best fit your current financial situation.