Credit Sesame explains how learning to pay down debt can be a great way to improve your finances.
If you’re unsure what to get someone as a gift, money is always a good option. The same goes for treating yourself.
Instead of an occasional night out or some new clothes, you could enjoy a permanent influx of cash by paying down your debts. Sounds counter-intuitive? However, it you eliminate a debt entirely, the monthly payment that you send to a credit card company or other lender for months, if not years, becomes money in your pocket that you can use any way you want to.
Benefits of paying down debt
One benefit of paying off or at least paying down your debts is freeing up your money for other things.
Everyone can use some extra cash, whether to pay other bills, save for a car or home purchase, fund retirement or an emergency stash, buy a new pair of shoes you need, or just to have fun and spend it on a night on the town.
There are also other benefits, including:
- Raising your credit score
- A lower debt-to-income ratio
- Reduced interest rates on credit cards and loans
- More budget flexibility
- Paying less interest
- Financial security
- Less anxiety
How interest can make debt a long-term problem
Interest that’s paid on a loan can make a loan last years longer than it if no interest were due.
Consider a $5,000 credit card balance with an interest rate of 18% and a minimum monthly paying off $125. A loan calculator calculates that it takes five years and two months to pay off the balance. The total interest paid is $2,692. That’s a long time and a huge amount of money when compared to the amount of the loan.
But suppose you manage to find an extra $125 per month and pay £250 per month. The debt is paid off in two years and the total interest drops to $989.
You just shaved three years off a major debt, paid less interest, and you put $250 back into your pocket each month much sooner. It’s like giving yourself a raise.
How to start paying down debts
The simplest way to pay down debts is to pay more than the minimum each month, and to pay more than once a month if you can. You have to be strict with yourself to reap the rewards of a shorter repayment period and less interest paid. This is easier said than done, of course. Here are some other options:
Pay off the most expensive loan first
Paying off loans with the highest interest rates first should save you the most money, especially if the interest accrues over a long time.
This is called the debt avalanche method. Make a list of your debts in order of interest rate.
Make the minimum payment on each debt, but pay as much as you can toward the debt with the highest rate. Once it’s paid off you apply that amount to the next debt on the list, even if it has a smaller balance than a debt below it.
Credit card balances generally have the highest interest rates, and should be paid off first. Personal loans and student loans usually have lower rates.
Remember that the goal with this method is to save money on interest. You save more money by paying off expensive loans first.
If you apply for a mortgage and want to reduce your credit utilization to help you qualify for a home loan, then you might be better off tackling the highest balances first instead of the highest rate.
Start a debt snowball
Another popular method of eliminating debt is the debt snowball method, which has been popularized by Dave Ramsey. It requires paying off debts in order of the smallest to the largest so that you gain momentum and quickly see progress.
When the smallest debt is paid in full, you roll the minimum payment you were making on that debt into the next smallest debt payment. You continue making minimum payments on all of your debts, and pay off as much as you can each month toward the smallest debt.
Side hustles, cutting spending, lowering expenses, and selling stuff are some ways to find the extra money to pay off your debts from smallest to largest, Ramsey advises.
A debt snowball gives you small victories as your debts are paid off. The smallest debt is paid off quickly and rolling the payments into the next debt should lead to all of your debts being erased faster. It should be a strong incentive to stick to the plan.
Consolidate loans
Multiple credit card debts can be consolidated into one loan that is cheaper than they are separately, usually. Debt consolidation companies can do this for you, though the costs may not be worth it and the loan payments may mostly drop by extending the loan over a longer time.
Alternatively, look for a 0% interest credit card transfer that allows debts to be added to one card and paid off over a year or so without any interest being charged. People with good to excellent credit are the most likely to qualify for these types of credit cards, but if you can get one it can be a smart way to pay off a few loans if you can find the extra money to do so within a year.
What about good debts?
Mortgages and student loans are considered “good debts” because they usually have lower interest rates than credit cards, and you’re getting something of value from the expense — a home or education. Home loans also have tax advantages.
Paying off good debts early should definitely be a goal, but probably after paying off higher interest loans and putting extra money into savings. You don’t want to have student loans or a mortgage forever, of course, but you should consider your other financial obligations and needs before paying good debts off early.
Use whichever payoff strategy that keeps you motivated to pay down debt. It isn’t much fun sending money to a lender each month, but it’s great to see your your debts reduced or eliminated. Keep in mind the extra funds at your disposal when your debts are paid should help you stay focused.
Consumers who enjoyed Pay Down Debt as a Financial Gift to Yourself may also be interested in:
- Focus on the Incentives for Improving Credit Score
- Debt and Credit Rank Fifth in Consumer Complaints
- States with the Most Credit Card Debt
Disclaimer: This guide to buying a house and getting a mortgage is for informational purposes only and is not intended as a substitute for professional advice.
