Debt can become a terrible burden. No wonder why many people ask the same question you’re asking right now—”how to pay off debt?”
If you have a steady income, it can be so easy to get a credit card, then another. Banks offer credit cards as soon as you get a job. If you’ve attended college, you may also have student loan debt. With the expensive cost of higher education, institutions are more than happy to sign you up for a loan.
Many people start with one credit card, spend a little bit, and pay it off, but things get out of hand. Your paycheck is a bit short, so you get groceries with your available credit. You pay the electric bill on credit just this once. Or you head to dinner with your friends and pay on credit.
It’s so easy to hand that piece of plastic to the waiter and deal with the consequences later. Soon you are up to your eyeballs in debt and wondering what happened. Financial worries keep people up at night, force them to get second jobs, and have them blocking bill collectors on their phones.
Rest assured that you are not alone. Millions of people are in the same situation as you are. But there are ways to break away from the nasty debt cycle. You need a plan to get out of debt, and we are here to give you some options on how to pay off debt. Keep reading for tips and tricks to get you started!
Why You Should Pay Off Debt
There are many reasons to work away at your debt payoff. Let’s take a look at just a few of those reasons so you can understand the importance of debt repayment.
To Increase Your Financial Security
Without debt payments, you can save for retirement, purchase a house, or prepare for your kid’s college fund (so they can start adult life without debt).
Paying off debts also puts your car and home in your own name, which reduces the risk of foreclosure or repossession.
Raise Your Credit Score
Carrying high credit card debt, even if you pay the minimum, can affect your credit score and result in higher interest rates and payments on future loans. It could also affect your ability even to get a loan.
Have Fewer Bills to Pay
Once you pay down credit card balances, you’ll find yourself with a lot fewer monthly obligations. Your monthly bills do not incur interest. That money can be earmarked for building wealth.
Have More Discretionary Income
Instead of credit card payments, you could spend your savings on a new couch or a dream vacation. Imagine paying cash for a new car or taking dancing lessons just because.
Regain Peace of Mind
Instead of having nightmares about where you will find the money to pay your bills, you can create a budget to make sure you can afford to live. Less stress makes you live longer—a win all around.
Paying off debt puts you in control of your money instead of the other way around.
Sets a Good Example For Your Kids
Children pick up financial habits from their parents. Paying off your debt and staying debt free shows them a better way to live. As they get older, involve your children in some age-appropriate financial discussions.
Teach them how to budget while you are trying to figure yours out and start them saving young. Discourage them from taking out credit until they are older.
Types of Debt
Before planning to pay off debt, it’s essential to understand the types of debt you have. You may want to prioritize debt payments based on the type or understand the fine print of those debt payments.
Secured debt requires collateral. If you fail to pay your debt, the lender may be able to claim cash or property.
For example, if you fail to pay your mortgage, you risk foreclosure. If you fail to pay your car loan, you risk repossession. Your car and your house represent collateral.
A secured credit card requires a cash deposit, which acts as collateral. Lenders often offer lower interest rates for secured loans.
Unsecured debt requires a higher credit score and could have higher interest rates.
Examples of unsecured debt are credit cards, student loans, and personal loans. If you fail to pay these bills, the lender could send you to collections, garnish your wages, or sue you for payment.
Revolving debt is a credit card with a balance or a personal line of credit. If your limit is $1,000 and you have a debt of $500, the amount you owe is your revolving debt. The rest is your available credit.
Your debt and available credit change each month based on what you pay, what you spend, and the interest you incur. If you pay your balance off each month, you could potentially avoid interest charges, but you still have debt from the time you charge something and when you pay it.
Installment debts are loans with a set amount of payments. Your car loan and mortgage are prime examples. You could also include personal loans or when you put something on layaway.
Interest fees are tied into each monthly payment unless you have an agreement of no interest for a set period of time. In that case, pay the loan off early. While the loan is out, you still have debt.
While some categorize debt as good or bad—good being house and car, and bad being credit cards—failing to pay any of these forms of debt will result in bad credit.
Making a plan to pay off all your debt is an excellent idea.
How to Pay Off Debt
Here are some of the common ways you can try to pay off debts:
One method of paying off your debt is called the debt avalanche. Using this method, list all debts except your mortgage. Then, focusing on the interest rate, put them in order from highest to lowest.
Pay the minimum payment on all of them except the one with the highest interest rate. Use all your extra money to pay this debt until it is paid off, then move on to the card with the next highest interest rate.
Proponents of this system argue that you are saving money on interest, which may partly be true. Critics say that most people are discouraged if the debt with the highest interest rate also has the highest balance.
Either way, you are making progress, so if it works for you, go for it.
Debt settlement is when you negotiate with your creditors—either by yourself or through an agency—to settle your debt for less than the total amount due.
When you agree on a settlement, you immediately pay the entire agreed-upon amount. Before you choose this option, find out what you’d be willing to settle for, plus any fees to an agency.
Settling debt by yourself involves calling your creditor and negotiating a lower interest rate, a settlement amount, or another type of agreement. Using an outside agency involves paying a fee (or percentage of your savings) to them on top of the settlement debt.
Either way, your credit takes a hit, and the amount of debt written off is taxable. On the upside, your debt is gone.
Debt settlement is sometimes risky as the creditor may not accept the settlement amount, you need to pay money upfront, your taxable income rises in that year, and you may owe more to the debt settlement company.
If the settlement takes time, you may incur late fees, and penalties on the debt you would have been paying for had you not started the process.
Debt settlement companies also require a lot of information, such as income, other debts, and additional personal information. They may put you on a budget and require you to work with a financial advisor.
Depending on your beliefs, having someone to hold your hand through the process can be helpful or intrusive.
Additionally, the debt settlement industry is full of people who want to scam you, so choose a reputable company and be aware of their terms upfront.
401(k) Early Withdrawals
If you have a sizable retirement account, you might consider utilizing that money to pay off debt. There are several ways you could do this:
Taking out a loan – If your 401(k) offers a loan option, you can take out a percentage of your balance and pay it back through deductions from your paycheck.
In essence, you are taking out a loan from yourself. There is a fee, and you are missing out on the growth and interest you would’ve earned by not touching that money. Plus, you are receiving a lower paycheck for the life of the loan.
Early withdrawals – If you are in a position to cash out part of your 401(k) and you are younger than 59 ½, you face stiff charges.
First, you are penalized 10% right off the top.
Second, you are taxed on your withdrawal amount on your subsequent income tax filing.
Depending on your withdrawal, this could push you up into the next tax bracket.
And again, you are missing out on the interest and growth that could make your retirement easier.
Hardship withdrawals – There are circumstances where you can withdraw money penalty-free, but paying off debt is not one of those.
You can use hardship withdrawals for medical expenses, costs related to purchasing your home, tuition, payments necessary to prevent eviction or foreclosure of your home, funeral expenses, or repair to your principal residence.
If one of those is a cause of your debt, check your 401(k) rules.
The CARES Act – During the pandemic, an additional hardship withdrawal was allowed for those who lost their job due to the virus, got sick, or were responsible for caring for a spouse or dependent.
The withdrawal limit doubled to $100,000, and the 10% fee is waived, but the amount is still subject to income tax.
Check with your 401(k) administrator to see if this is still an option.
Most financial advisors do not recommend touching your 401(k) as the cost of withdrawing the money is high upfront and in potential retirement earnings.
Weigh the loss of investment dollars vs. your situation. If you are facing bankruptcy or foreclosure, it is an option.
Taking On a Loan to Pay Off Debt
Another option is to take out a loan with a lower interest rate to pay off higher interest rate debts. Many companies offer unsecured loans, and some use your home or retirement account as collateral.
While taking a loan might seem like a good idea, you must be careful not to get into further debt. Taking out a loan is just moving your debt around. You may save interest and have some relief temporarily, but your debt is still there.
The first thing to do before attempting any debt program is to stop spending money.
Do not pay your debt with a loan and keep spending money on credit cards or take out another loan because you are overspending.
Evaluate your relationship with money and find out how you can stay debt free once you are debt free.
Tips For Paying Off Debt
Before paying off debts, you need to figure out where you stand.
Write down (or track in a spreadsheet or app) all of your bills and outstanding debts.
List the balances, minimum payments, and due dates. Note their interest rate.
Estimate your variable spending, including groceries and gas.
Look at your income and see if you have enough money to pay for all of the items, at least with the minimum payment.
You’ll need to look for ways to add more income if you cannot. You could get a second job, borrow from family or friends, or explore one of the options in this article.
Focus everything on paying off your debt. Do not add more debt. Learn to say no and potentially sacrifice some of your “normal” lifestyle choices for a better life.
Gone are the days of keeping up with the Joneses—besides, how do you know they aren’t in the same situation?
Here are some tips for making progress on those balances:
Pay More Than Once a Month
Credit cards and loans list a minimum payment each month. That amount usually doesn’t make much progress toward paying off the balance, so one option is to send more than one payment to a credit card.
First, ensure that the minimum payment is received by the due date. You will be ahead of the game if you can make another minimum payment (or any extra amount).
If you pay the minimum payment in two installments, as long as it’s received by the due date, it can still make a difference in your balance.
Credit cards have a balance/utilization ratio, which tracks how much debt is used at a given time. This ratio factors into your credit score, so the more you pay, the lower the ratio.
Pay Off Your Most Expensive Loan First
You could look at this in two ways: the credit card with the highest balance or the debt with the highest interest rate. The one with the highest interest rate costs you more monthly.
Paying off the debt with the highest balance would encourage your end goal of being debt free. This is called the debt avalanche method.
Keep Track of Bills & Pay On Time
Paying off debt requires discipline. If you tend to forget when a payment is due, create a spreadsheet, use a filing system, write it on your calendar, download an app to track your bills, or schedule automatic payments through your financial institution.
Many companies will be happy to send you text messages or email reminders. Late payments result in extra fees, interest, and a ding to your credit score.
Get On a Budget
Creating a budget provides a plan for your money and a guide in which to follow to pay off your debt.
A budget creates an awareness of income and expenses. It shows you when you’ll have extra money to pay off your debts or when you might have a shortfall.
There are a couple of ways to create a budget:
Every Dollar – this budget accounts for every single dollar and covers all expenses—fixed, variable, discretionary, etc.
You’ll have line items for every bill and expense, including groceries, car gas, and daily coffee stop. If the expense is not in the budget, you don’t spend it.
50-30-20 – this budget allocates 50% to your needs, 30% to wants, and 20% to paying for retirement or temporarily paying off long-term debts.
Mortgage or rent, insurance, utilities, groceries, and minimum payments on debts are included in the needs category.
Entertainment, clothes, and other discretionary spending is in the want category.
The saving/retirement/debt payment category can be used to pay off debts.
Once the debts are under control, the money needs to be earmarked back into retirement and savings.
Other budgeting theories include paying all bills first and seeing what is left over for food, debt payment, and entertainment.
The best budget is one that you can follow and will stick to. The most important point is that while you are on a debt reduction plan, you may need to cut out excess spending and focus any extra money on paying creditors.
Pay Off Debt Before Investing in Retirement
We were taught to invest money for our retirement starting as early as possible, but if you are in debt, that money would best be used to pay down debt.
The exception to this rule is if your employer offers a 401(k) in which they match a percentage of your contribution.
In that case, you’d be passing up essentially free money if you didn’t contribute up to the match amount.
After that, wait until your debt is paid off and an emergency account is funded before continuing to save for retirement.
Your focus now needs to be on one thing—paying off debt. That debt is costing you money, and the sooner you get rid of it, the sooner you’ll be able to start building your nest egg.
Stop Using Credit Cards
This seems logical, but people often set aside credit cards until their debt is paid off or manageable. But those credit cards are a temptation that you don’t need.
Instead, learn how to save and pay cash for everything. Learn to tell yourself no when you don’t have the money on hand and are earmarked for the expense. This new way of thinking will keep you debt free after all of your hard work spent getting there.
You need a credit card for very few things—most places will accept a debit card.
Using a debit card will prevent overspending, as you can only spend money in your account. Be sure only to use that debit card for things in your budget.
Lower Your Expenses
Even if your budget shows that you can pay your bills and add extra to debt repayments, your goal might be to get there faster.
At this point, look at your budget and see where you can cut costs even further:
- Cook at home instead of heading to a restaurant.
- Take leftovers for lunch.
- Make your coffee to go.
- Find cheaper forms of entertainment – free days at the museum, hikes in the park, or movie rentals from the library.
- Cut out gym memberships or apps that you pay for and never use.
- Check with your insurance company for better rates.
- Sell your brand new car with expensive payments and pick one more affordable than you can pay cash for.
- The possibilities are endless.
Use those savings to make extra debt payments.
On the flip side, you could find ways to increase your income by selling stuff you don’t use, getting a second job in your spare time, asking for a raise, working overtime, or starting a side hustle.
Strategies for Paying Off Debt
It seems like everyone has a strategy for paying off debts faster. Here are some of the more popular methods:
The Debt Snowball
The debt snowball makes a list of all of your debts in order from highest to lowest.
You make minimum payments on all the debts except the one with the lowest balance. Throw all of your extra money into paying off this debt.
Once that is paid—congratulate yourself for the small win and move on to the debt with the next lowest balance.
Take all the money you’d been sending to the first debt and send it to the second debt on top of the minimum payment you’d been making.
When you get to the higher balances, you are making large payments, and the debt disappears quickly.
The Debt Avalanche
The debt avalanche works the same as the debt snowball method, except that you are tackling the debts costing you the most—the ones with the highest balances and/or interest rates.
Aside from your mortgage and perhaps car payments, start focusing on the biggest debt first.
Once that is paid off, target the second biggest debt, and so on.
There are several ways to consolidate your debt.
Transfer balances from a credit card with a higher interest rate to one with a lower one. The idea is to save interest payments while working on paying down your debt.
There is often a fee associated with the transfer, so make sure you take that into account when considering this option. After you transfer the money, use one of the other strategies to pay down the debt. And do not use a credit card that is now paid off for any reason.
Home Equity Loan – if you’ve paid a significant portion of your home off, you can apply for a home equity line of credit or a home equity loan. Using your home as collateral, you switch from paying a credit card to essentially paying a second mortgage.
Be aware of the interest rate, any fees, and closing costs. Be aware of the risk because they could take your house if you default on a home equity loan.
An unsecured personal line of credit can often be obtained from your financial institution. Once you qualify and if the interest rate is less than your other credit cards, you can make one payment instead of several.
Some companies specialize in debt consolidation. Discover what they offer and what it will cost you before agreeing to anything.
Debt Management Plan
If you need extra support making a plan or struggle with making regular payments, a nonprofit credit counseling agency may be able to help. They will start by helping you list all your debts and then create a budget.
If you cannot make payments, the agency will negotiate with your creditors, possibly lowering payments, setting up payment plans, or arranging for debt forgiveness.
The Bottom Line On Debt
It took time for you to get into debt, and it will take time to get out of it. Getting out of debt is about more than throwing money at bills. What would prevent you from ending up in the same situation again if you got a windfall and could pay off all of your debts at once?
Before you start to pursue debt repayments, spend some time thinking about the reasons why you want to get out of debt. How did you get into debt, and what are you willing to do to get out? Consider the sacrifices you are willing to make to secure a better financial future.