3 Ways to Dig Out of Your Pile of Debt
It’s the sad truth: Many of us are facing a mountain of credit card debt.
In fact, the average U.S. household carries $16,061 in credit card debt, according to an analysis conducted by NerdWallet.com.
Meanwhile, more than half of Americans surveyed by the Federal Reserve said they carried a credit card balance at least some of the time. Of those who carried a balance, about half said they made only the minimum payment on their cards, meaning their debt continues to grow as interest piles up.
That is perhaps unsurprising when you consider that nearly 18 percent of people say they spend more than their household income, according to the FINRA Investor Education Foundation’s National Financial Capability Study.
But with credit card interest rates likely to increase in the coming years as the Fed increases its benchmark interest rate, there’s no time like now to try to get out of debt.
But what’s the best strategy for paying it down? You have options:
The Debt Snowball
Are you the kind of person who needs periodic gratification to speed you along toward achieving your goals? If so, the so-called “debt snowball” method might be right for you.
Under this scenario, you would first make minimum payments on all of your credit cards. You would use any remaining available dollars to wipe out your smallest balance, regardless of its interest rate. You would then move on to the next smallest balance.
What’s the potential advantage? The satisfaction you get from paying off your small debts will help you build momentum—just like a snowball rolling down a hill.
Cardholders who concentrate their repayments on one of their accounts pay down more of their debt than those who spread their dollars equally across their various accounts, according to recent research by Keri Kettle, Remi Trudel, Simon Blanchard and Gerald Häubl, who analyzed three years’ worth of spending and repayment patterns for close to 6,000 people who had multiple credit cards.
In addition, the researchers conducted a series of experiments in a behavioral lab to dig into the psychological effects of different repayment strategies. The results showed that it isn’t the actual dollar amount of a debt repayment, or how little is left on a balance that has the biggest impact on people’s perception of progress. What matters most is the portion of the balance that they pay off.
“Putting money into the smallest account provides the greatest perception of progress towards getting out of debt, which then motivates you to continue to repay your debt,” said Trudel, who is a professor at the Questrom School of Business at Boston University.
The Debt Avalanche
If you’re disciplined, and you’re determined to save as much money as possible, the debt avalanche approach strategy to controlling credit card debt is a good way to go.
With the “debt avalanche” approach, borrowers concentrate their efforts on knocking off their highest interest rate debts first, regardless of the size of the balance. By following this path, you will pay less in overall interest charges and you’ll get out of debt faster.
Let's say you have a $3,000 balance on a credit card that charges 18 percent APR and requires a minimum payment of 2.5 percent each month.
Assuming you didn’t charge a single penny more, it would take you 263 months—nearly 22 years—to pay off that debt. The total amount you would pay for that $3,000 charge would be $4,115.44.
“Someone who understands compound interest and the impact on a high-interest rate balance, might prefer to attack the balance with the highest annual percentage rate first,” said Beverly Harzog, the author of the book “The Debt Escape Plan.”
Keep in mind, if you have a large balance, it might take some time to pay it off. You might get discouraged and stop making payments. But if you stick to this path, you’ll save money in the long run.
The Debt Blizzard
If the previous two winter-themed options don’t seem right for you, Harzog recommends you consider a third approach, which she calls the “debt blizzard.”
This method combines features of the debt snowball and the debt avalanche. You first attack your smallest balance to get a psychological boost. You then switch to the avalanche method to maximize your savings.
“The debt blizzard is a good choice for someone who needs a quick boost to get motivated, but then who is ready to mentally switch gears and focus on saving the most money,” Harzog wrote in a blog post.
The bottom line: There’s more than one strategy for paying down your credit card debt. The key is to commit to paying down debt, then find the method that fits your personality, and your financial situation, and stick to it.
“The best debt-reduction strategy is the one that works for you,” Harzog said.