The complete guide to paying down debt
Why should I pay off my debt as soon as possible, instead of continuing to pay the minimum payments?
Although by paying less per month your cash flow may be better, this doesn't mean you are saving anything in the long run. The more you are able to pay now, the less interest you will ultimately pay over the life of the loan.
Consider this example: With a $50,000 loan at 5% interest rate, you will pay the loan off in full (plus $34,865.47 in interest) in just over 23 years if you pay $300 a month. If you pay $500 a month, you will pay the loan off in 11 years paying just $14458.45 in interest (a savings of over $20k for just $200 more a month.) If you are also able to refinance the debt to a lower interest rate, your savings can even be substantially higher.
But should I be saving or investing my money instead of paying down the loans?
Mathematically (in most cases), no. Here is the argument for paying down debt before investing:
Paying down a high interest debt is mathematically equivalent to getting that return in the stock market (i.e. if you pay down a 6% debt, it's as though you "earned" 6% on an investment.) The difference is that paying down a 6% loan is a guaranteed 6% return, whereas the market is never guaranteed. It may return much higher than 6% but also has the potential for substantially negative returns. Most financial professionals agree that the guaranteed return is preferable to the possible higher return [with a risk of loss]. The results may vary if your interest rates are very low (see step 5).
For further discussion on the optimal order of debt, saving, and investing, click here.
So, how to go about paying down my debt?
Step 0. Reduce your expenses. If you are having trouble paying down your debt, the absolute first thing you must do is reduce all unnecessary expenses. It will be much more challenging to pay down your debt if you spend money imprudently now and allow additional interest to accrue. (For tips on reducing your expenses, click here.)
Step 1. Create an emergency fund. It is critical that you develop an emergency fund of at least 1 months expenses for any unforeseen emergencies that arise, such as health or medical emergencies, or unexpected job loss. (3-6 months is sometimes recommended, but if you have high-interest debt it is advisable to keep a smaller emergency fund in order to tackle the debt first). This step should be taken before aggressively paying down debt, but while maintaining the minimum monthly payments on your debt. (Note that the emergency fund does not need to be three to six months salary, only the expenses you would absolutely need if you did not have income during this time.) This means sitting down and creating a budget that includes 100% necessary expenses but excludes discretionary spending that you could cut in an emergency (that means you, Netflix). (To read all about emergency funds, click here.)
Step 2. Create a list of all the debts you owe.
Including the type of debt, the interest rate, and any other necessary considerations such as overdraft or prepayment fees. Before you even begin to pay, look at this list and make sure that all of the debts are correct. This means asking:
"Is the debt valid and does the debt actually belong to me?" -Debt cannot be inherited from a family member. -Parent PLUS Loans are held in the parents name and cannot be transferred to the student. -Very old debts past the statute of limitation cannot be collected by debt collectors. (Varies by type of debt). -Make sure it's not something you already paid, either to the vendor or a collections agency. Everyone makes mistakes and you don't want to pay twice.
Step 3a. Negotiating the debt. In some but not all circumstances you may be able to reduce the principal or interest rate of your debt. Medical bills If the debt is for medical bills, you can often negotiate a payment plan or offer a reduced amount if paid in full now. Collections Debt with a collection agency is often eligible for a settlement as well. Call a representative and ask what amount they would accept to clear the debt in full; you may be able to negotiate a much lower amount when you pay a lump sum. Just make sure to keep good records of the calls you make and request any settlement agreement in writing. Credit cards For a small balance transfer fee you may be able to move your credit card debt to a 0% introductory rate credit card. This is only beneficial if you think you will be able to pay the entire balance at the end of the promotional period without missing a payment. Otherwise, you may want to look into refinancing (see step 3b). Student loans You may be able to get a very slight discount on the interest rate with automatic debit bill pay. Other than this, the best option for reducing the interest rate on your student loans is by refinancing. Read about how to save money on student loans.
Step 3b. Refinancing You may have heard the term refinancing before and been unsure what this is or if it is right for you. Refinancing can sounds complicated, but at its simplest, it is simply taking out a new loan with better terms to pay off an older, worse loan.
Refinancing a loan may be a good option for you if any of the following 3 things apply to you:
-You want to take advantage of a better interest rate or loan terms -You want to consolidate other debt(s) into one loan -To reduce or alter risk (by switching from a variable-rate to a fixed-rate loan)
(Some people also refinance to reduce the monthly repayment amount to free up cash, although we advocate paying as much as you are able to towards high interest debt)
In most circumstances, there is no downside to getting a quote to see if you can refinance.
How to refinance?
-For credit card debt, medical debt, car loans, and many other types of debt, you can compare lending options at PersonalLoans.com. Look at several options before determining which offers you the greatest benefit.
-For student loans, two of the most highly recommended refinancing companies are SoFi and CommonBond. It is free to get quotes and there is no obligation. Depending on a variety of factors, refinancing can save you thousands of dollars on the overall debt, so it is worth checking what you qualify for.
Step 4. Paying the remaining debt The method we recommend for debt repayment is known as the Avalanche Method. This means that the highest interest rate that is paid first, then the second highest, and so on. While doing so, you should still be making the minimum payments all debts, regardless of their interest rates.
(The opposite method is called the Snowball Method [popularized by Dave Ramsey] which involves paying down the smallest debt at first no matter the interest rate. Although there are some psychological benefits to paying down some of your debts in full, the Avalanche Method is mathematically superior in terms of the total amount paid, so we will not address the Snowball Method here. If you would like to read more about the Snowball Method this is a good resource.)
Step 5. What loans should I keep? (advanced only).
This portion is very subjective. As discussed in the intro, high interest debt should always be paid down before any investing. However, what constitutes “high interest” is different for everyone. Some people are averse to holding any debt and opt to pay it off immediately. Some people hang on to some debt if they can get a better return on their money elsewhere, like in an IRA. Although not a hard and fast rule, the consensus is that you will benefit from paying down any debt above approximately 3%. If you can refinance other debts into this range, then you may consider exploring other investing options.
Now that you understand how to cut your expenses and pay down your debt, read up on what to do with your savings or how to make extra money.
If you have a more complex scenario or feel that your questions were not answered by this guide, find a financial advisor you can trust in minutes with WealthMinder.
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