If you feel overwhelmed by debt, you're not alone.
In 2019, the average American owed more than $6,800 across four credit cards.
One of the biggest challenges of getting out of debt is knowing where to begin.
Having a specific method can help.
Here are three strategies to pay off debt, especially debt with an interest rate higher
than 5%:
the avalanche method, where you pay off debt with the highest interest first,
the snowball method, where you pay off the smallest balance first,
and consolidation, where you combine your debt.
We'll walk through each method to help you determine which one may be right for you.
While it may require some sacrifices, it is possible to dig yourself out of debt one
step at a time.
Let's say you have debt on four different credit cards.
To start, write down all your outstanding balances and the interest rates on each.
Based on these totals, if you only paid the minimum on each card, you might not be debt
free for almost 12 years.
With the avalanche method, you'll prioritize paying off the debt with the highest interest
first.
The idea is by focusing on the most expensive debt first, you'll save money over time.
For the other cards, pay the minimum every month, then put everything else you can toward
paying off the highest interest rate card in this example, the one with the 22% interest
rate.
After the highest interest rate debt is paid off, you'll apply those payments to debt
with the next highest rate, and so on.
The avalanche method will save you more money in interest payments than if you were to pay
off lower interest debt first, so mathematically, the avalanche method is a better way to pay
off debt.
If you're able to put an extra $500 per month toward this debt, the avalanche method
could save you more than $21,000 in interest compared to just paying the minimum.
It'd also shorten the life of your debt to only three years.
But for some, avalanches have to start somewhere maybe as a snowball.
With the snowball method, you'll pay the minimum of all your balances and put anything
left toward the debt with the smallest balance first.
So, in this example, you'd pay off the $1,300 debt first.
It may seem financially unwise to pay off anything but the highest interest debt first,
but with the snowball method, you're able to pay off a higher portion of one of your
balances with each payment.
Take that $1,300 debt: a $500 payment would pay off 38% of that account while $500 toward
the debt with the highest interest rate would only be 5% of that account balance.
A study in the Journal of Consumer Research found that when subjects paid down a higher
portion of a balance on their debt, they were more motivated to keep going.
Though it's not the most cost-efficient method, in the long run, it was more effective.
Don't underestimate the power of psychology.
The sense of accomplishment from completely paying off one balance can motivate you to
stay disciplined with the others.
A third method of debt repayment is consolidation.
This is combining all your debt into one, so you make a single monthly payment, ideally,
one with a lower interest rate than your existing accounts.
One way to consolidate debt is to take out a new loan or line of credit to pay off your
existing debt.
Another choice is a balance transfer, which means moving your balances onto a new credit
card.
This may be a good idea if you're able to open a new credit card
that offers 0% interest on balance transfers.
But typically, this 0% interest is only for a limited time, like a year or 18 months.
So don't transfer your balances unless you're sure you can pay them off during this introductory
period or if the new interest rate will be lower than your current combined interest
rate.
In our example, if you combined everything into a 0% balance transfer for 12 months,
you'd face payments of $2,500 per month.
That's pretty steep, so make sure you'll be able to handle that amount, or you'll
face interest at the end of the intro period.
So, to review, avalanche saves money by paying debt with the highest interest rate first,
snowball may maximize motivation by paying the smallest balance first, and consolidation
may be useful if you can afford to combine all your debt into one payment.
There isn't one right way to dig your way out of debt.
Your numbers may be different than the ones we used in our example, which means the difference
between total payoff could vary from one strategy to the next.
The most important thing is to stop adding to the debt, determine exactly how much you
owe, pay as much toward it as you can, and stick to it.