Did you know that 77% of Americans carry some amount of debt? Now part of that is to be expected. For most of us, we simply can’t purchase a home without borrowing. However, a 2018 Northwestern Mutual study showed that, exclusive of mortgages, average household debt is $38,000. Credit card debt makes up the largest part of that followed by student loans and then car loans.
Debt can be a real financial drain. The Northwestern Mutual study found that 20% of those with debt had to contribute 50-100% of their income towards debt repayment! Okay, so how do folks dig out once they find themselves with significant debt?
Well, the first thing to do is to stop making things worse. You must stop adding to debt in order to have a chance at eliminating the debt you already have. In addition, you want to avoid the large penalty charges by making the minimum monthly payment on all of your debts. This seems so obvious, but in practice many of us continue to rack up more and more debt.
After you’ve stopped the bleeding, there are two proven techniques for retiring your existing debt. In approach one, you simply enter all of your debts into a spreadsheet. Have the spreadsheet calculate total monthly interest payments (loan balance times the interest rate). Then you retire the loans as fast as circumstance s permit from highest interest payment to lowest. Note that as each debt is retired, the minimum payment that you’d been making for that debt can be added to your monthly debt-reduction amount. For example, suppose you find a way to apply $500/month to debt reduction. And suppose the minimum monthly payment for the debt you just retired was $55/month. Once it’s paid off, you now have $555/month available to retire the remaining debts. As you continue paying off debts, the amount available for debt reduction continues to increase. This result has been called the Snowball Effect.
In the second approach, you make a list of all you debts as you did in the first approach. This time you order them from smallest amount owed to largest. Then you pay them off in that order, adding the retired debt payments to the new loan. The Snowball Effect still applies.
Which approach is best for you? That depends on your personal circumstances and psychology. Approach one minimizes your overall interest expenses, but approach two gives you some early wins that motivate a lot of us to keep at it. A rule of thumb that I like is to use approach two for the smaller debts that can be retired in 6-12 months. For the bigger debts, approach one is often the way to go.
If you’d like some help figuring out how best to retire your debts, or have any other financial questions, we’d be pleased to discuss your particular situation in a no-charge, no-obligation initial meeting. Just visit our website or give us a call at 970.419.8212 to learn more.
This article is for informational purposes only. This website does not provide tax or investment advice, nor is it an offer or solicitation of any kind to buy or sell any investment products. Please consult your tax or investment advisor for specific advice.