Not all debt is bad debt. But bad debt can weigh heavily on your shoulders and cause long-term financial strain.
Here’s the good news about bad debt: you can reduce it.
If you have a clear overview of your outstanding debts and amounts, you can get rid of your debts with the following tips.
1. Check your spending habits
Your expenses are divided into “necessities” and “nice-to-haves”. “Necessities” means food, accommodation, utilities, transportation and clothing. “Nice-to-haves” are everything else.
As you pay down debt, you can’t cut back on the expenses you absolutely have to have. But you can cut back on the expenses you do want to have and use the extra money to pay off a credit card or loan.
Cancel that gym membership you’re not using. Eat out less often or drink less coffee. Cancel that streaming subscription you’re not using. If you cancel a $15-per-month streaming subscription, you’ll have $180 more per year to put toward paying off debt.
2. Determine the right withdrawal approach for your situation
The usual approaches to debt repayment are snowball and avalanche principles.
Debt avalanche – the smallest first
The debt snowball strategy involves making minimum payments on all credit accounts and loans – except the account with the smallest balance, into which you put all the extra dollars. Once you’ve paid off that balance, turn to the account with the next smallest balance and work on that. Continue this approach until your debt is paid off.
By paying down your balances, the amount you have available grows into a larger sum, allowing you to pay off your bills faster.
The main benefit of the snowball strategy is the quick wins. Seeing a zero credit card balance within a few months can motivate you to keep going. But as you pay off smaller amounts, your account balances will continue to grow with higher interest, making this method potentially more costly.
Debt avalanche – a great start
With the debt avalanche strategy, you make minimum payments on all accounts. Your main focus and money is on the balance with the highest interest rate. Once the balance reaches zero, you focus on the card or loan with the next highest interest rate and reduce it.
The debt avalanche approach involves paying off the most expensive debts first, saving you interest payments. However, this strategy requires motivation and persistence. Your higher interest accounts might also be the accounts with the highest balance, which could take longer to pay off.
3. Go beyond the minimum
If you pay more than the minimum amount on a credit card or loan, your balance will be reduced to zero more quickly – and you will save the additional interest.
Let’s say your credit card has an interest rate of 20 percent and a balance of $5,000. If you pay a monthly payment of $100 on that balance, it will take more than nine years (109 months) to pay it off. But if you increase that payment to $200, the repayment time drops to just two and three-quarter years (33 months).
Paying more than the minimum amount can also lower your credit utilization ratio, which is a percentage that measures how much credit you use relative to your available credit amount. A lower utilization ratio improves your credit score.
Use Bankrate’s credit card repayment calculator to determine minimum payment amounts, interest charges, and how long it will take to pay off a balance.
One way to generate extra cash is to reduce expenses. You can also use unexpected amounts, whether large or small, to reduce those debt levels.
Taking advantage of the financial windfall
If you’ve received an unexpected windfall, such as a large cash boost from a tax refund, a work bonus, or money from a generous relative, use some of it to pay off your debt and keep a little to treat yourself to a night out or another fun activity. Every little bit helps as you work toward your debt payoff goals.
Achieve small savings
You can also reduce your debt using the debt snowflake strategy. This method requires you to find small savings and put those little extras into paying off debt. There are many ways to do this, for example:
- Buying generics
- Using coupons for purchases
- Carpooling saves petrol
- Reduction of water and electricity consumption
No, a few dollars a week won’t pay off your debt overnight. But remember how many snowflakes can make big snowdrifts. Likewise, small savings can help reduce your debt.
5. Consider debt consolidation methods
A debt consolidation loan or transferring your debt to a 0% APR credit card is one way to manage your debt. Both methods allow you to pay off multiple creditors and lenders, leaving you with just a single monthly fee that is applied to the remaining balance of the loan or card.
This approach can make budgeting easier (you avoid making multiple payments on one). You may also have more money for that payment because you’ve eliminated several credit card and lender interest charges.
However, be sure to look for information such as interest rates and loan terms (the time period in which you have to repay the loan) before you sign.
6. Start with a debt settlement plan
A debt settlement plan (DMP) can help you in the following ways:
- You work with a credit counseling agency to develop a budget for managing your finances.
- This agency works with creditors to negotiate concessions such as fee waivers or reduced interest rates.
- If creditors agree to cooperate, you make a monthly payment to the credit counseling agency, which in turn pays each creditor.
There are a few caveats here. First, reputable DMP agencies are nonprofit, but you will likely pay a fee tied to your monthly payments.
Second, it’s not a good idea to open new lines of credit or take out loans while on the plan. You’re using the DMP to pay off debt, not to accumulate new debt. Additionally, if you recently took out a DMP (which could be reflected in your credit report), lenders and creditors may be hesitant to give you a loan or credit card. Those that do may only offer bad credit rates, which means a higher annual percentage rate (APR) or fee.
7. Settle for less than you owe
A debt settlement program allows you to reach an agreement with your creditors for less than the amount you owe.
You can either handle the matter yourself or hire a third-party debt settlement company to negotiate with creditors on your behalf. Depending on the terms of the agreement, you could end up paying less than you owe (through a lump sum) or interest rates and fees could be reduced or waived entirely.
Jennings noted that debt settlement may be an option for those who are unable to meet their payment obligations. However, “it could significantly impact creditworthiness and have tax implications on the forgiven debt,” he said.
The conclusion
Bad debt is not desirable. But it is possible to get rid of it. By following the strategies above, you can reduce your debt while improving your financial health. As you reduce your debt, examine and change behaviors that got you into this situation in the first place to prevent you from heading in the same direction once you have fully paid off your debt.
Frequently Asked Questions
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Too much debt is a problem if you rely on credit cards for everyday purchases or use them to pay off other debts. It’s also problematic if you can only make minimum payments on those cards.
According to Qualified Financial Advisor (QFA) and CFA charterholder Ian Jennings, debt can also have an emotional impact. “Financial stress can lead to strained relationships, reduced quality of life and limited financial freedom,” Jennings said. “Managing and reducing debt is critical to overall well-being and achieving financial security.”
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Not necessarily, but don’t let that stop you from taking steps to reduce your debt.
When assessing creditworthiness, the Fair Isaac Corporation (FICO) looks at your payment history, which makes up 35% of the overall credit score. Thirty percent of this score is your credit utilization, which is what you owe compared to the amount you owe.
Even if you pay everything on time, your credit score can suffer if you max out your credit cards (which can happen if you have a lot of debt). Don’t use more than 30% of all your credit to build your credit score. For example, if your total credit is $5,000, keep your debt under $1,500.
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An effective budget for debt reduction is the 50/30/20 method. This approach involves using 50% of your net income for your “essential” expenses, 30% for discretionary (non-essential) spending, and the remaining 20% for saving and debt reduction.
If you want to pay off your debt faster, you can apply some of that 30% to your credit card balances.
