Debt is a problem that we all face at one time or another to some degree. Sometimes, it is just bad luck, but most of the time, it is good people that made terrible choices. Regardless of what got you in debt in the first place, there is always a way to get out of debt, and you might be able to pay off all your debts quickly if you have a plan and can make some sacrifices.
Before you try to figure out how to get rid of your debt, you have to get rid of the habits and lifestyle that got you into this mess in the first place. If you habitually spend more than you can afford, you need to fix this first. Learn to manage your expenses and live within your financial means. Otherwise, all your effort will be for naught, and you’ll end up even worse.
How to Pay Off Your Debts Quickly
Now that you have your spending habits under control, it’s time to start working on your debt.
1. Make a List
Make a list of your debts with the creditor’s name, amount owes, interest rate, and type (i.e., secured loan versus unsecured loan).
Since your secured loans are collateralized, you could lose your home, car, or other valuables if you default on these loans. Therefore, these are the most critical loans to keep your eyes on. Whatever you ended up doing, your plan must be able to support the monthly payment of these loans.
Next, focus on debts with the highest interest rates — e.g., your credit cards. You want to get rid of your higher interest loans as quickly as possible to save money on interest expenses.
In short, you should have a list grouped by secured versus unsecured, and sorted by the interest rate.
2. Negotiate with Your Lenders
Many people often overlook the option of negotiating with credit card companies and other lenders as a way to lower your interest rates and payments. Call each of your lenders and ask them for a lower interest rate or a different payment term. Some will work with you, and some will not. The important thing is to ask and see if you can lower your interest rates and minimize expenses.
3. Do-It-Yourself Debt Consolidation
You may think it’s crazy to borrow more money at this point, but the important thing to do is to lower your monthly expenses as much as possible. Therefore, IF you can borrow money at a lower interest rate, you should do it and use that money to pay down your higher interest loans. The primary goal is to reduce the number of loans and the overall interest rate.
Here are some alternative funding sources that you can investigate:
- Personal loan — Check with your local banks and credit unions for a personal loan. Often, they can offer you a loan at a lower interest rate than what credit card companies charge. If you can handle the fees and the terms, consider taking out a personal loan to pay down your higher interest debts.
- Credit card transfers — The next option is to search for credit cards that offer 0% APR on balance transfer with minimal or no fee. Use this as an opportunity to get rid of your higher interest loans. However, note that the 0% APR offer usually lasts only 6 to 12 months, and the interest rates could increase dramatically. Be sure you know what the resulting interest rates will be, and be ready to go through another balance transfer cycle in 6 to 12 months.
- Borrow from social lending networks — Peer-to-peer lending networks, such as Lending Club and Prosper, let you borrow up to $40,000 with a fixed interest rate. Interest rates depend on a variety of factors, including your credit score, credit history, debt-to-income ratio, and the loan amount. Be sure to study these networks carefully before asking for a loan. If the loan works to your advantage, take out a loan to pay off your higher interest loans.
- Life Insurance — If you have a life insurance policy, it may be worthwhile to borrow against the cash value of the policy and use the money to pay down your higher interest loans. However, this option will lower your death benefit and significantly stunt your insurance policy value.
The first four debt consolidation options are reasonably harmless if you run into trouble down the road. For the next three options, make sure you understand the risks involved because we are now putting your house and retirement on the line.
- 401(k) loan — This is an option, but considers it very carefully since there are many risks involved. If you can execute it properly, this option could be beneficial. Read Should I Borrow From My 401k Plan? for more information.
- Cash out refinance — If you own a home, you could look at refinancing your home and cash out a portion of your equity. Use this cash out amount to pay down your higher interest loans. The caution here is that your mortgage is a secured loan, so make sure you can afford to make the new monthly mortgage payment, or you could lose your home.
- Home equity loan — This is similar to cash out refinancing, but you are taking out a second loan against your home instead of refinancing your mortgage. The caveat is the same, a home equity loan is a secured loan. If you do this, make sure you can make the monthly payments for both your mortgage and the home equity loan, or you could lose your home.
4. Debt Snowball or Debt Avalanche
With the first three steps, you should be able to eliminate a few higher interest loans and consolidated them into other lower interest loans. Now, it’s time to pay them off in a systematic way.
Let’s say you are at a point where you have enough money to make the minimum payment on all of your debts, and you have some extra money left, what should you do with the extra cash?
The answer is to use all the remaining money to pay down your highest interest debt (if you prefer the original Debt Snowball method popularized by Dave Ramsey, you can pay down your lowest balance debt first). As you eliminate one debt, shift all the extra money toward the next highest interest loan. As each debt is eliminated, you can pay the next debt down with more money and keep the momentum going.
For example, let’s say you have these loans, each with a $25 minimum payment.
- Debt A = $1,300 at 16%
- Debt B = $1,700 at 12%
- Debt C = $1,200 at 10%
- Debt D = $2,500 at 5%
Assuming monthly compounding and you pay just the minimum due at $25 each:
- You’d have paid $1,500 after 15 months.
- Your balance would’ve decreased from $6,700 to $6,067, a reduction of $663.
- You’d have paid $867 in interest.
- …and, there is no end in sight
So paying just the minimum is not going to work. Let’s assume you pay $500 a month, this is how the payments look like using the Debt Avalanche method.
Using Debt Avalanche, paying $500 a month:
- You’d have paid $6,997 after 14 months.
- Your balance would’ve decreased from $6,700 to $0.
- You’d have paid $297 in interest.
- …and, YOU ARE DEBT FREE!!!
Using the Debt Snowball method would result in a slightly higher total interest payment of $339.
If you want to get out of debt, these steps can help you accomplish your goal more quickly and efficiently. Remember, the key is to change your spending habits and not go further into debt; otherwise, your debt repayment plan will fail. Once you have your spending under control, the key steps are to (1) list your debt according to the interest rates (2) negotiate better terms, (3) consolidate your debts into lower interest rate loans, and (4) to use Debt Snowball or Debt Avalanche to pay down your debt quickly.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.