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Has worry about your debt taken over your life? Are you just barely keeping your head above water, making minimum payments and throwing money away on interest, but never really making a dent in your debt? You aren't alone. Right now, the average American household carries $5,700 in credit card debt, and the average student loan debt is around $30,000.
Debt reduction benefits you by improving your credit profile, loan rates, and interest payments — not to mention the benefit of peace of mind. But when your debt feels overwhelming, where do you even start?
Luckily, you have several options. This guide will discuss the top five debt reduction strategies:
- Credit Counseling
- Debt Settlement
- Do-It-Yourself Debt Payoff Plan
How do you know which option is right for you? Follow these two steps to find out.
Assess Your Situation
Before you can resolve your debt, you need a clear picture of your finances. This step may seem unpleasant and will take some work, but you need to find out where your money is going, see your current net worth, and understand your total credit profile. Start by gathering all your financial information into one place. To get the complete picture, do the following:
- Download your latest bank, loan and credit card statements.
- Write down each debt total, including the interest rate and minimum monthly payment.
- Write down your total monthly income and average monthly expenses.
- List your assets, such as home equity, savings, car values, etc.
- Order your credit report and credit score from www.AnnualCreditReport.com (find more info about monitoring your credit using MoneyGeek's Credit Monitoring Guide).
Now that you have all this information in one place, you can clearly see where your money is going, and the role debt plays in your overall financial situation.
Next, take the quick quiz below to define your financial goals and find the debt-reducing option that works best for you.
Identify Your Priorities
There is no one-size-fits-all plan when it comes to reducing debt. Everyone's financial situation is unique, and what's best for you may not be best for someone else. Each debt reduction strategy has pros and cons, and you may choose to use more than one to tackle your debt. Ultimately, choosing the right option starts with defining your priorities. Is your credit score you highest concern? Short time to debt freedom? Smallest possible monthly payment? Take the quiz below to find the plan that fits your needs best.
If you'd prefer guidance and a plan of action for tackling your debts, and you're willing to pay a little bit for it, then you might consider credit counseling. A credit counseling firm will work with you to come up with a "debt management" plan, and for a fee — either a fixed value or a small percentage of the face value of your debts — they can help simplify your debt payoff and possibly save you a considerable amount of money in interest. You simply pay the credit counseling organization one monthly payment, and the counselors will use that money to pay your creditors. As with any debt reduction option, credit counseling has its pros and cons:
Pros of Credit Counseling
- Credit counseling firms will work directly with your creditors to help lower your interest rates and create reasonable payment plans.
- Credit counselors are trained in consumer credit, debt management, and budgeting, and they can help you start on a plan to better manage your money.
- Credit counselors create a plan to pay down your debt on an agreed-upon schedule with your creditors, and paying on time can help improve your credit score.
Cons of Credit Counseling
- Working with a credit-counseling organization usually involves a fee.
- Some creditors will not agree to work with credit counselors. (It's a good idea to call creditors ahead of time to see if they are willing to do this.)
- Not all credit-counseling organizations employ certified credit counselors.
As with any option, do some research before choosing to work with a credit-counseling firm, to ensure it is reputable.
As with any option, do some research before choosing to work with a credit-counseling firm, to ensure it is reputable.
Many unsecured debts come with high-interest rates that make up the majority of your monthly payments so that it takes much longer to pay down debt. Saving even a few interest percentage points by securing that debt could save you hundreds of dollars per month, helping you pay off your debt much more quickly. With a home equity loan or a cash-out refinance, you can use the equity in your home to help you pay off your debt. These loans effectively secure the debt to your home, which in turn provides you with a lower interest rate for the debt you pay off.
Pros of Refinancing for Debt Payoff
- You can pay off all your unsecured debt with your home equity, turning the debt pay-down amount into one easy monthly payment.
- Paying off all your unsecured debt, especially if you were behind on payments, can help increase your credit score.
- Paying off all your debt with a cash-out refinance or line of credit can stop all the collections calls and harassment from your old creditors.
Cons of Refinancing for Debt Payoff
- Securing your debt to your house increases the risk of losing your home if you aren't able to pay down the new mortgage or line of credit.
- Paying off all your debts with a refinance carries the risk of getting back into debt, as it does not change your spending habits.
- Refinancing your debt can come with fees, especially when doing a cash-out refinance.
Make sure to shop around for the best rates, and work with a reputable bank to see which option fits your situation best.
Debt settlement is a plan that allows a consumer with a large amount of debt to pay cents on the dollar for the outstanding debt and settle with that creditor. This is especially helpful to those who have debt they cannot afford to repay and are looking to start over. A debt settlement company will set up a debt payoff program with your creditors and negotiate the total debt down to an amount that is agreed upon by you and the creditor.
Pros of Debt Settlement
- Debt settlement offers significant savings by enabling you to pay off debts for much less than what is owed. This could save tens of thousands of dollars.
- Debt settlement companies set up affordable monthly payment agreements, so paying off debt won't break the bank each month.
- Debt settlement will help stop creditors from coming after property to settle the debt.
Cons of Debt Settlement
- Debt settlement reflects poorly on your credit score since it means paying less than the amount owed. This can affect future borrowing.
- When you settle your debt, the "forgiven" portion of your debt is counted as taxable income. So $10,000 of your debt is forgiven, you will pay taxes on that $10,000.
- Unfortunately, there are many scams related to debt settlement. You must do your research to find a reputable debt settlement company to work with.
Bankruptcy can seem like a scary word, but it's just one of the options you have, especially if you're looking to clear up your debt quickly. Those who declare bankruptcy are looking for a fresh start, a way to clear their debts and start from square one. This option is not for everyone and should not be taken lightly. You should weigh the pros and cons before going this route. But if it fits your situation, it can be a great option to help you eliminate your debt and start over.
There are many forms of bankruptcy (called "chapters") and consumers usually qualify for either chapter 7 or chapter 13 bankruptcy. Chapter 7 bankruptcy wipes out all qualifying debts immediately. Chapter 13 is a court-ordered payment plan that lasts up to 5 years, after which any remaining debt usually discharged (zeroed out). An experienced bankruptcy lawyer can tell you if you qualify for a chapter 7 or 13 bankruptcy.
Pros of Bankruptcy
- Chapter 7 bankruptcy can wipe out most unsecured debts, including credit card debt.
- Chapter 7 bankruptcy only takes 4-6 months to complete, usually costs less than $400 (depending on your situation) and commonly requires only one trip to the courthouse.
- Chapter 7 bankruptcy causes an "automatic stay," or an immediate halt on creditors' actions to collect the debt. It keeps most creditors from garnishing your wages, emptying your bank account or going after any of your property of value.
Cons of Bankruptcy
- It won't clear certain debts, including student loans, taxes owed, child support and alimony. This means you must continue paying these as normal.
- Your credit score may take a large hit, especially if your score was decent before filing. This can affect your loan rates and approval for borrowing until the score goes back up, which may take some time.
- Creditors can still challenge a discharge of your debt in court. If they win, it could effectively waste your time and money and cause you to still owe the debt.
If you choose to pursue this option, please do so with a trusted bankruptcy lawyer or professional to ensure you are fully informed.
The Do-it-Yourself, 3-Step Debt-Payoff Plan
It may seem impossible right now, but you actually can put together a plan to pay off debt by yourself. Doing this enables you to break the process down into manageable steps that are truly tailored to your situation. Paying off a large amount of debt is all about putting together a clear, actionable plan and being determined to build new money habits that get and keep you out of debt. Below, we've laid out a three-step plan for paying off your debt. As always, there are positives and negatives associated with this debt-payoff method.
The Pros of a Debt-Payoff Plan
- Building and sticking to a debt-payoff plan will help you develop new money habits that can keep you from going back into debt once you are debt-free.
- As each debt is paid off, your debt-to-income ratio improves, which in turn improves your credit score.
- You are fully in control of your money and payoff schedule using this plan.
The Cons of a Debt-Payoff Plan
- You can end up paying more in interest if you pay off all the debt, as opposed to settling.
- This plan will not remove any liens or judgments against you until the debt is paid off.
- This plan requires your commitment to a long-term plan, and it may be hard to stick to such a plan if you have significant debt.
3-Steps to Paying Off Debt Yourself
Step 1: Track Your Spending and Prepare a Budget
Before you can put together your debt-payoff plan, you need to find out where all your money is currently going. Track your monthly spending by doing the following:
- Download your credit card and bank statements for the past two months.
- Next to each transaction, write down a category name (Groceries, Restaurants, Utilities, Entertainment, etc.).
- Total the spending for each of those categories. You can do this in a spreadsheet or as a simple list on a piece of paper.
- Calculate the average monthly spending in each category over those two months to figure out your regular spending for each.
This process will give you a baseline for your typical spending per month. Next, put together a budget to show where you'd like your money to be going. The goal here is to ensure you set aside money for paying down your debt—more than just the minimum payments. Find a way to reduce your spending enough to save 10 percent toward your debt reduction each month.
Putting together your budget is fairly simple:
- Place your monthly (take-home) income at the top.
- Next, list your fixed monthly expenses. These are recurring bills that you pay each month (such as rent/mortgage payments, utilities, services, insurance, etc.) and are not debts.
- Next, add your variable expenses. These are expenses that vary from month to month (such as groceries, entertainment, gas, restaurants, etc.).
- Next, add your debt payments. Include the minimum payment amount for each debt.
- Next, add your contributions to savings. You still need to account for things like Christmas, birthdays, anniversaries, travel, car and home maintenance, etc.
- Total these up, and subtract this total from the total monthly income. This shows how much is left for extra debt payoff.
After you subtract your monthly expenses from your monthly income, you will have a clear picture of where you stand financially. This is your starting point. It's likely that you'll need to adjust the budget items to hit your target savings. Even small changes can have a big impact on how quickly you pay off your debt. Here are a few examples:
- Cut out your daily latte, and you might save over $100 per month.
- Pack lunch instead of eating out once a week, and you can save $30-$50 per month.
- Skip a trip to the movies once a month and save $25-$50 per month.
These are small sacrifices that add up to HUGE savings. Just following the three recommendations above can give you an extra $3,000 or more annually—that's money you can use to pay on your debt!
Step 2: Negotiate and Consolidate
Attempting to get lower interest rates on your higher-interest debts could ease the burden of paying off your debt. Start by calling up your highest-interest debt creditor and requesting a lower interest rate. Make sure you are current on your payments before calling.
For your credit cards, you might consider transferring your highest-interest balances to a no-interest credit card. There are many cards out there offering 0% introductory interest rates for up to 24 months. If you sign up for a card with a 0% interest rate, contact the credit card company with the card you are transferring to and ask to do a balance transfer from the card with the high interest. (Be aware that this may lower your credit score.) Many card companies will even remove the "balance transfer fee" (usually around 3 - 5%) if you just ask. Also, ask if you can transfer multiple card balances over—this may help consolidate your debt and lower the interest rates for multiple accounts.
If any of your debt account balances are over 50 percent of the available lines of credit for those accounts, this can adversely affect your credit score. To get your balances below this threshold, call the creditors and ask if they can raise your credit limit. If this isn't possible, consider transferring that debt to another account. This will help protect your credit score as you pay down your debt.
Step 3: Create a Payment Plan and Stick to it
Tackling the debt is important, and the most important piece of this plan is staying on track. To help ensure you stick with your debt-payoff plan, experts recommended that you put aside a small emergency fund in case of life "hiccups" that could throw you off financially. Two thousand dollars should be sufficient for most life emergencies, but if you think it would take too long to accumulate this much, start with $1,000 in a savings account. With your budget in place, direct any extra money here first, and then start your payoff plan.
Once you have your budget in place and have negotiated down your interest rates, you can develop your payment plan. Start by putting your payment due dates and payment amounts on your calendar each month to ensure you don't miss payments. Consider signing up for automatic bill pay through your bank so all bills are paid on time. Alternatively, you can register for online payments through your creditors directly. Often, this generates automated email bill reminders that show minimum payments, due dates, and total balances.
As you pay down your debt, here are a few tips that can help keep you on track:
- Consider tracking your credit profile along the way, to ensure creditors are doing their job by reporting your debt payments and payoffs to the credit bureaus. You can sign up for a credit-monitoring service that alerts you of updates to your report, provides you with score updates, and helps keep track of any credit activity under your name.
- If access to your credit card causes you to go further into debt, consider freezing your credit cards—literally. Stick your credit cards in a container of water, and put them in the freezer to stop yourself from using them.
- Celebrate the wins. As you hit each debt-payoff milestone, do a mini-celebration. Buy yourself something small or do something nice for yourself. These celebrations help keep you motivated during your debt-payoff journey.
Finally, there are two methods for determining the order in which you pay off debts: the Debt Avalanche and the Debt Snowball. These methods are described below—pick the method that best fits your situation.
The Debt Avalanche method helps you save money on interest when paying down your debts. The idea is that you prioritize your highest-interest debts first in your debt-payoff plan. Here's how it works:
- List your debt amounts in order from highest-interest debt to lowest, top to bottom.
- Next to each debt amount, write the minimum payment for each debt. In this method, you will only be making the minimum payments on each debt EXCEPT the first one (the one with the highest interest).
- Apply any amount leftover in your budget for debt payoff toward debt number 1. Shoot for 10 percent of your monthly income to be applied to this debt.
- After debt number 1 is paid off, repeat the process by tackling the next debt on the list. You should be able to roll the payment for the first debt into the original 10 percent, making for a larger payment that can be applied to #2 (this is the "avalanche").
- Pay minimum payments on all debts except for the one at the top of the list—the highest-interest debt.
- Continue the avalanche until all debt is paid off.
As you can see, as you continue going down the list paying off each debt, the amount you can pay down keeps growing because you no longer need to pay the minimum payments on the eliminated debt. This turns the payoff amount into an avalanche that crushes your debt. It also addresses your high-interest debts at the beginning, significantly lowering the amount you pay in interest as each debt gets paid off.
The Debt Snowball method is similar in that you tackle one debt at a time. However, the payoff order is not dictated by interest rates. Instead, the Debt Snowball prioritizes total amounts owed, putting the lowest debt amount at the top of the list. Though you do pay slightly more in interest overall, this method may keep people motivated during the debt-payoff journey by enabling them to see debts paid off quickly. Here's how it works:
- Make a list of your debt amounts in order from the lowest amount up top to the highest amount at the bottom.
- Next to each amount, write down the minimum payment for each debt. You will make the minimum payment on each debt EXCEPT the first one.
- Apply all excess money left over in your budget toward paying off debt number 1. Shoot for 10 percent of your monthly income.
- After debt number 1 is paid off, repeat the process with the next debt on the list, rolling the original payment from number 1 into the original 10 percent of your income you have been using to pay debts (this becomes your "snowball").
- Pay minimum payments on all debts except for the top item (the lowest debt amount).
- Continue until paid off.
As you continue paying off each debt, the amount you can pay toward debt keeps growing because you no longer need to pay the minimum payments on the eliminated debt. Your payments continue to snowball, growing with each debt you pay off so you can pay off increasingly larger debts. Toward the end, you will have a large amount that you are able to pay toward your debt each month.
The psychology of the Debt Snowball is that you get quick wins (the small debts) that give you a feeling of success, motivating you to stay on track and tackle the next debt. This can help those with large amounts of debt to keep going over the debt-payoff journey ahead.
Every journey starts with one step. When paying off debt, every little bit counts, and there's no way to make progress without taking that first step. Find the plan that works for you and take action to get started as soon as possible. The sooner you are debt-free, the sooner you can start building wealth and have the financial life you've always wanted.
Glossary: Key Terms You Need to Know About Debt
Consumers have several forms of bankruptcy available to them. Chapter 13 bankruptcy is a court-approved payment plan (usually 5 years in length) creditors must accept. Chapter 7 bankruptcy discharges (cancels) qualifying debt immediately.
An agreement where parties make mutual promises. In the context of this page, a creditor promises to lend money to a debtor, who promises to repay the money with interest.
A two-part process where a consumer creates a budget with a credit counseling agency that includes a plan to repay all debts (usually credit card balances) over 5 years. The payment plan is known as a Debt Management Plan (DMP).
The creditor is the person (or company) to whom you owe money.
Debt Management Plan
A payment plan created by a credit counselor to repay all credit card balances in full over 5 years. Credit cards included in a DMP are closed.
An aggressive form of debt resolution where the consumer/debtor stops making payments to the lender and instead makes regular payments into a special savings account. A debt settlement negotiator reaches agreements with the consumer's creditors for less than the balance owed, paying the creditors from the special savings account. Typical settlements range from 50 to 60 cents on the dollar owed.
A debtor owes money to someone. Also known as a borrower.
Deed of Trust
A form of home loan common in western U.S. states. For all intents and purposes, a deed of trust is the same as a mortgage, but legally the two are distinct. A deed of trust is a form of secured loan.
The difference between the value of a property and the balance of the loan securing the property. For example, if a property has a fair market value of $100,000 and the balance of the mortgage on the property is $30,000, the owner's equity is $70,000.
Fair Debt Collection Practices Act (FDCPA)
A federal law that prohibits abusive practices by debt collectors. The Federal Trade Commission enforces the FDCPA.
A decision by a court the debtor owes the creditor a certain amount of money. A judgment is a possible result of a trial.
A creditor becomes a "judgment creditor" if a court awards a judgment against you.
A complaint filed in a court of law that claims a harm that has a legal remedy. In the context of this page, a lender would claim a borrower broke their promise to repay a debt according to the contract the borrower signed.
A form of home loan where the property is the security.
A new home loan where the owner finds a new loan that replaces an existing mortgage or deed of trust with loan terms that are more favorable to the owner. For example, a homeowner may refinance to a loan with a lower interest rate. Alternatively, the homeowner may trade equity in the home for cash. This is known as a cash-out refinance.
Statute of Limitations
A deadline setting the time period during which someone can file an action against a defendant. In debt-related lawsuits, a defendant must assert a statute of limitations defense.
A loan where property or goods are used as security against non-payment. If the borrower (debtor) fails to repay a secured loan, the lender (creditor) has the right to take possession of the security. Mortgages and automobile loans are the most common secured loans. (Contrast with Unsecured loan.)
A loan based on the promise of the borrower (debtor) to repay a loan to a lender (creditor). Credit card debt, student loans, and signature loans are examples of unsecured loans.
Experts' Advice on Debt Reduction
- How can individuals determine which debt reduction option is best for their unique situation?
- How can individuals build a sustainable financial plan that addresses both short-term and long-term debt reduction goals?
- How can individuals avoid falling back into debt after completing a debt resolution program?
Financial Coach & Host of the "CentsAble Chat" Podcast
About Joanne Liu
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