How to pay off a debt

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While your debt doesn’t have to define who you are, the money you owe plays an important role in shaping your personal finances. These contracts, and the way you pay off your debt, influence the terms under which you will be able to access credit in the future.

Whenever you need to borrow money, whether it’s to buy a house, finance a car, pay for medical procedures, or continue your education, a lender will look at your debt-to-income ratio – how much you owe against. how much you earn – as well as your credit report, from which your credit score is drawn. The lower your credit score, the higher the interest rate you will be charged on your loan.

Why paying down debt is so important

So, if you want to boost your credit score, paying off obligations like credit card debt is the fastest way to do it. “Your debt plays a huge role in calculating the credit score,” says Galen Gondolfi, spokesperson for Justine Petersen, a non-profit financial education and assistance organization based in St. Louis.

While an on-time payment history is the most important component of your FICO credit score (the most commonly used scoring model) at 35%, your debt-to-credit balance is your credit ratio. use of credit, in terms of financial advisor – contributes another 30% of this score.

The best thing you can do for your credit score is to keep your usage rate as low as possible. “We encourage people to have less than 30%, but the lower the better, of course,” says Gondolfi. For example, if your maximum available credit is, say, $ 10,000, try to keep your balance below $ 3,000.

There are different schools of thought on how to pay off debt: Even personal financial advisers know that no one approach is right for everyone – and a combination of strategies might work best for you. Here are the best tips and tactics credit experts recommend to get you on your way to paying off your debt.

Increase your monthly payments

The first step to paying off debt is to increase the amount of money you invest to pay it off. These are basic budgeting calculations: if you only make minimum monthly credit card payments, you’re hardly reducing principal. If you have to spend less money to pay interest, the debt is paid off faster.

Even if you have good credit, experts say you are playing with fire if you have a high amount of debt. “We should be concerned about the debt, regardless of the impact on that score,” Gondolfi said. While this hasn’t hurt your credit yet, it could change quickly if you lose your job, especially if you are one of the many people who don’t have sizable emergency funds in your bank account.

If you have both debt and a meager checking account balance, which should you prioritize first? This question is often asked by personal finance professionals like credit counselors, and there is no right answer. If your household has more than one source of income, focusing on your debt is a good idea, because even if you lose your job, you can always at least start making minimum monthly payments on your credit card balances again. .

If your family is dependent on one income, your best bet is divide and conquer: put money aside, even if it’s a small amount, and budget an equal amount for the principal balance. of your debts. Although it may take longer to break free from debt, it’s important to have an emergency fund so that you don’t have to take on high interest credit card debt when unforeseen expenses arise. . Federal Reserve data shows that the Average Annual Rate (APR) on an interest-earning revolving credit account is just over 16%, and borrowers with checkered credit histories often pay much higher interest rates than that .

Use the “avalanche” method

Mathematically, you can get the most out of your dollars – and get out of debt faster – if you target the outstanding balance with the highest interest rate. You might hear a counselor from a credit counseling agency or other personal financial aid organization call this the “avalanche method”.

“As a credit counseling agency, we generally recommend that people tackle debt with the highest interest rate first,” said Becky House, spokesperson for American Financial Solutions, a Seattle-based credit and finance counseling organization. “As they pay off the accounts, we recommend that they reallocate the payment from the paid account in full to the creditor with the higher interest rate. We know, logically, that it saves money, ”she said.

If you have other types of non-mortgage debt, like a car loan, personal loan, student loans, or medical bills, include those as well. The idea behind “the debt avalanche” is to eliminate these high APR bonds as quickly as possible. Removing an outstanding balance on a credit card that carries a high interest rate frees up extra money that can speed up your debt repayment goals.

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Use the “snowball” method

The “snowball” method is another way to tackle credit card debt or other high interest debt, using a tactic endorsed by personal finance guru Dave Ramsey. Like the Avalanche Method, you strategically apply extra money to pay off your debts. The main difference is how you prioritize these payments.

The snowball method works like this: you first funnel your extra funds to pay off your smaller debt (just watch out for minimum payments on others, of course), then apply the money you would have spent each month on. service this debt to your next highest credit card balance, and so on.

There is compelling evidence to suggest that the “snowball” method is effective from a psychological standpoint, House says. “We all want results now and it can be difficult to keep up the momentum and enthusiasm when it feels like progress is slow,” she admits. “So putting more money into smaller accounts and seeing those paid in full faster can really motivate people,” she says.

While this is obviously not a quick fix if you have a lot of debt, snowball enthusiasts say people are more likely to stay motivated when they see the smallest balance wiped out.

Transfer debt to a credit card

If you have a good credit rating, one tactic that can speed up the debt repayment process is to apply for a credit card with balance transfer. Look for a 0% APR introductory period of at least 12 months. Since the transfer fee can be as high as 5%, do some comparison, especially if you want to transfer a large amount of money.

Calculate the amount of your debt repayments to bring your balance back to $ 0 before the end of the promotional period. If you’re only making minimum payments, there’s a good chance you’ll still be owed when your new balance transfer card’s regular APR goes into effect. The caveat is that you should only follow this advice if you are confident in your ability to control your spending and will run out of credit card debt after making a balance transfer to a new card. “If you have a card that is out of balance, it can be terribly tempting to go back and use that empty card,” warns Jeff Richardson, spokesperson for VantageScore Solutions, a Stamford, Connecticut-based company. which provides a credit scoring formula used by the three major credit bureaus.

Apply for a debt consolidation loan

If you don’t want to transfer your debt balances to a credit card, or if you have debts like a car loan or student loans that will take years to pay off, Richardson says another debt repayment option is a debt consolidation loan.

It is essentially an unsecured personal loan, although some financial service providers market loans specifically for debt consolidation. If you’re struggling to break free from debt because you’re struggling with high credit card interest, this option can give you a bit of a break. These loans usually have fixed APRs that can be several percentage points lower than credit card interest rates.

Unlike revolving lines of credit, personal loans are installment loans, meaning they have fixed maturities. You can choose a repayment plan that fits your budget, as some issuers offer maturities that can span five years or more. Of course, the longer the repayment term, the more interest you will pay over the life of the loan, so it is in your best interest to find the shortest term for which you can manage the monthly payment.

Installment loans are also viewed more favorably than revolving lines of credit by conventional credit scoring models, meaning that adding credit could improve your credit profile (provided, of course, that you regularly make your payments in a timely manner).

Finally, if you can’t or don’t want to open new loan accounts or new lines of credit, Richardson suggests calling your credit card issuers and charging each a lower interest rate. While there is no guarantee that they will say yes, it literally costs nothing to give it a go. If you are a good borrower, your APR could be reduced by a few percentage points, which will reduce the cost of servicing your debt.

“It can’t hurt to ask for a lower interest rate,” says Richardson. “There is no harm in that.”

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