Five Ways You Can Defeat Debt

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Jan 2021

Debt and the American way of life have become synonymous. From the 1850s when the Singer sewing machine company first introduced installment loans so that more homes could purchase its revolutionary appliance, a rising standard of living and debt have gone hand in hand.

In 2018, less than a quarter of respondents to a Northwestern Mutual survey said they were debt-free. The rest reported debt totaling an average of about $38,000, excluding a home mortgage. Cumulatively, all consumer debt surpassed $14 trillion in the beginning of 2019. For perspective, the GDP of the U.S. in 2019 will be around $21.4 trillion, China’s GDP will be $15.5 trillion and Germany $4.4 trillion. In fact, U.S. consumer debt surpasses the GDP of 8 of the top 10 countries with the largest economies in the world. The largest single category of U.S. consumer debt is mortgages, totaling $9.4 trillion. But that still leaves a chunk of debt rivaling the size of Germany’s whole economy made up of student loans ($1.4 trillion), auto loans ($1.3 trillion), credit cards ($834 billion) and personal loans ($291 billion.)

Debt has clearly become the albatross of the American family budget. And while not all debt is bad, [link to good debt blog] some types of debt can be destructive, nibble away at your finances and give you that “I just can’t get ahead” feeling. High credit balances and low savings can be a one-two punch that prevents you from accumulating sufficient savings to insulate yourself from financial stress.

The road to recovery? Reduce debt. You could just keep making your current payments, but unless your debt is structured in an unusual way, that’s probably the most costly and difficult way to do it in terms of payoff amount and duration.

Once incurred, debt can be mighty hard to get rid of. But here are five ways to overcome those pesky, persistent loan balances.

Snowball Method

Look at your lowest credit balance. Maybe it’s a retail store credit card or a low-balance credit card you don’t use much. Take everything you can scrape together and throw it at that card each month until it’s paid off. Now do that again with the next highest balance, and so on. This is part financial strategy and part behavior modification: By “removing” those payments from your budget, you start building a reserve into your monthly spending habits. And that reserve gets bigger and bigger as you move up to the higher balances. Eventually, you’ll pay off enough of your debt to be able to start diverting some of that reserve into savings. Win!

Avalanche Method

The snowball is highly effective in motivating you to act and keep with the program; however, it may not result in the lowest overall payments. If that’s your goal, and you can stay motivated, consider the avalanche: making minimum payments on all of your debts along with the biggest additional payment you can on the debt that has the highest interest rate, often a credit card. When that’s paid off, do it again with the debt with the next highest interest rate, and keep following that pattern until you pay off your lowest-rate debt. This approach will save more money on interest over time.

Prioritize Bad Debt

If you go into debt to buy a house or get an education in a field that’s going to pay well enough to repay the loan or start a profitable business, that’s good debt. You’re investing money in a way that can help eventually increase your net worth. Bad debt includes money borrowed for things that decrease in value as soon as you buy them or debt taken on for purchases that are beyond your budget. That could include discretionary credit card purchases for nonessential items or a car loan for a vehicle you really can’t afford.

The strategy here is to focus on paying off bad debt first by making more than the minimum payments to get out from under. Often, bad debt carries higher interest rates, so you may also save some interest costs by doing this. But the main benefit is that you’ll feel better by decreasing your bad debt — and be in a better financial position — if you owe money on a house that builds equity and provides a place to live than if you owe money on a new wardrobe that will probably be out of style by next year.

Biweekly Payments

This strategy is simple, straightforward and fiscally sound: Take each of your monthly payments and split them in half. Make one of those payments every other week. Because there are 52 weeks in the year, you’re actually making one additional monthly payment, 13, each year. In addition, you’re lowering your loan balance more rapidly. Both of those things will save you money on interest. This is especially effective when used on longer term obligations like an auto loan, student loan or mortgage.

For example, if you have a 30-year fixed mortgage of $250,000 at 4%, making biweekly payments will save almost $30,000 in interest and retire the loan five years sooner. Even if you only stay in the house for seven years, you’ll still save several thousand in interest while paying down an extra $10,000 in principal, which means more money in your pocket when you sell. It takes discipline to stick to this program, and you have to make sure your lender will allow this and then apply the additional payments correctly, but there are biweekly loan services that can help for a fee.

Balance Transfer/Consolidation

Of the five strategies, this is probably the least desirable, but it can save money without requiring larger payments. If you have credit card debt, you’ve doubtless received offers for consolidation loans or balance-transfer credit cards. The idea is to move balances from higher-interest loans to a loan or card with a lower interest rate. Over time, that can save you money on interest.

However, read the offers carefully: Many have a transfer fee, and that fee can severely limit the amount you save. Also, with balance-transfer credit cards, the introductory “low, low rate” often only lasts a few months to a year. If you can’t substantially pay down that balance before the rate goes up, you’re not making any real progress.

Which One Is Best?

Like diet and exercise, the best debt-reduction strategy is the one you’ll actually follow over the long term. Pick a path that fits your personality, your finances and your lifestyle, and then stick to it and it will — literally — pay off.

Sources:

https://news.northwesternmutual.com/planning-and-progress-2018

https://www.marketwatch.com/story/us-consumer-debt-is-now-breaching-levels-last-reached-during-the-2008-financial-crisis-2019-06-19

http://worldpopulationreview.com/countries/countries-by-gdp/

https://www.fool.com/investing/2019/04/03/how-much-debt-do-americans-have.aspx

https://www.nerdwallet.com/blog/mortgages/should-you-make-biweekly-mortgage-payments/

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