Choosing the right debt repayment strategy is important. You want see quick progress, but also would probably like to have some extra money to help you get through each month.
If you’re struggling to make your monthly payments or are paying a shockingly high amount of money just to cover the minimum payments each month, it’s important to choose an effective payoff strategy and figure out which loan to pay off first.
Table of Contents
Key Points
- Debt snowball and debt avalanche are good starter strategies
- If your credit score is good, debt consolidation may be a good option
- If you have more than $10,000 in unsecured debt, debt settlement may be your best way out
- The key is to commit to a realistic payoff strategy that works best for you
Six Simple Debt Repayment Strategies
Americans have a total of more than $17 trillion in debt. That breaks down to about $97,000 per capita. That’s significantly more than a full year of wages for many, considering that the average annual salary is about $58,000.
Many who want to become debt-free don’t even know where to start.
Should you put it in savings? Pay off the house? Pay off that medical bill? It’s overwhelming.
Option 1: Pay Off the Highest-Interest Debt First
- How it works: Make a list of all of your debts and the interest rates you’re paying. Make the minimum payment on all of your accounts, then pay whatever you have left toward the bill with the highest interest rate. This is also known as debt avalanche.
- Advantages: You pay less money in interest over the life of your loans by first paying off the ones that charge higher interest rates.
- Disadvantages: It can be slow to see progress, so if you need constant motivation, this may not be the options for you.
READ MORE: Debt avalanche
Real World Example
Let’s say you have seven debts:
- Credit card debt 1: $3,000 balance at 20% APR
- Credit card debt 2: $10,000 balance at 14% APR
- Personal loan: $12,000 balance at 10% APR
- Medical bill: $2,000 balance at 8.75% APR
- Auto loan: $25,000 balance at 7% APR
- Student loan: $12,000 balance at 6% APR
- Home loan: $120,000 balance at 3% APR
Using the debt avalanche method, you would pay them off in the order listed above, even though you have other debts with larger balances. Thus, you would make the minimum monthly payment on the other six debts, then pay as much as you can toward credit card debt 1. When that debt is paid off, move on to the next with the next highest interest rate, which would be credit card debt 2, then on to the personal loan. Repeat this method until only your home loan remains.
Option 2: Pay Off Your Smallest Debt First
- How it works: As with avalanche, you start with making a list of all of your debts and the interest rates you’re paying. Make the minimum payment on all of your accounts, then pay whatever you have left toward the bill with the smallest balance. This is also known as debt snowball. Because the smallest loans have the shortest repayment terms, you’ll feel like you’re making major accomplishments.
- Advantages: This gives you a series of quick wins, which can be a powerful motivational tool. And financial guru Dave Ramsey is a key supporter of the snowball method, saying that the mental boost you get from each quick win helps keep you going.
- Disadvantages: You’ll pay the most money in interest over the life of your loans.
Pro tip: Even if they have the lowest balances, pay off your home loan, federal student loans and medical bills after you’ve repaid your other debts. These have extra protections and/or tax advantages that you don’t want to lose until your other debts are squared away. Private student loans are a different issue that we will explore later.
READ MORE: Can’t afford to pay your medical bills? Here’s what happens next
Real World Example
Let’s say you have the same seven debts as the example above.
- Credit card debt 1: $3,000 balance at 20% APR
- Credit card debt 2: $10,000 balance at 14% APR
- Personal loan: $12,000 balance at 10% APR
- Medical bill: $2,000 balance at 8.75% APR
- Auto loan: $25,000 balance at 7% APR
- Student loan: $12,000 balance at 6% APR
- Home loan: $120,000 balance at 3% APR
Using the debt snowball method, you’d start pay paying off credit card debt 1, then credit card debt 2, the personal loan and the auto loan. After that, tackle the medical bill, the student loan and finally, the home loan.
Option 3: Pay the Debts that Most Affect Your Credit Score
- How it works: Available credit and credit utilization are key components of your credit score. This means that if you have a credit card bill that’s close to your credit limit (even if the credit limit is low), it will impact your credit score more than a larger debt on a card with a higher credit limit. You will need to list your debts, interest rates and credit limits for each account. If you’re already behind on payments, note that as well.
- Advantages: Some quick adjustments can boost your credit score fast. This is particularly useful if you need to consolidate other debts, or are planning to purchase a car or home. It can also be a powerful motivator to be able to see the changes on your credit report.
- Disadvantages: It will take some time and research to figure out where you’ll get the biggest gains, and you may end up paying debts with lower interest rates first.
READ MORE: Reasons your credit score dropped
Real World Example
Once again, we’ll use the same debt example, but this time will note the credit limit when applicable:
- Credit card debt 1: $3,000 balance at 20% APR, credit limit of $25,000
- Credit card debt 2: $10,000 balance at 14% APR, credit limit of $12,000
- Personal loan: $12,000 balance at 10% APR
- Medical bill: $2,000 balance at 8.75% APR, fixed monthly payment of $100
- Auto loan: $25,000 balance at 7% APR, but you have missed two consecutive monthly payments
- Student loan: $12,000 balance at 6% APR, you haven’t had to make payments due to the federal payment pause, but now have to tack on another payment each month.
- Home loan: $120,000 balance at 3% APR
To get the biggest credit score bump, you’ll start by bringing your auto loan up to date. You don’t want to risk repossession, and on-time payments are the biggest component of your credit score. Meanwhile, only pay the minimum toward your other debts. After that, credit card debt 2 has a very high credit utilization rate. Focus on repaying that one next. As your credit utilization rate on that account decreases, your credit score will start to rise. At that point, you may be able to consolidate your credit card debts and personal loans, or try refinancing your car loan to one with a lower interest rate.
Option 4: Debt Consolidation
- How it works: You apply for a new loan with a lower interest rate, and use that loan to pay off your other higher-interest debts.
- Advantages: This leaves you with one monthly payment for most of your unsecured debts.
- Disadvantages: You will need to have a relatively high credit score in order for a lender to give you a lower-interest-rate loan.
READ MORE: Best debt consolidation loans
Real World Example
- Credit card debt 1: $3,000 balance at 20% APR, credit limit of $25,000
- Credit card debt 2: $10,000 balance at 14% APR, credit limit of $12,000
- Personal loan: $12,000 balance at 10% APR
- Medical bill: $2,000 balance at 8.75% APR, fixed monthly payment of $100
- Auto loan: $25,000 balance at 7% APR, you have missed two consecutive payments
- Student loan: $12,000 balance at 6% APR, you haven’t had to make payments due to the federal payment pause, but now have to tack on another payment each month.
- Home loan: $120,000 balance at 3% APR
To consolidate your debts, you would start by applying for a debt consolidation loan large enough to pay off the two credit card debts and the personal loan. If the interest rate on the new loan is low enough, you could roll the medical bill into it as well. That means you’d need a loan of about $27,000 to pay off those four bills. You’d be left with four monthly bills: The home loan, student loan, auto loan and consolidation loan.
Alternatively, if you have enough home equity, a home equity loan or home equity line of credit would allow you to roll everything into one loan with an interest rate of around 7%. You would be left with two monthly payments, your home loan and your home equity loan.
Pro tip: In this example, it WILL NOT make sense to refinance your mortgage. The current high interest rates for mortgages will make a cash-out refinance extremely expensive. You do not want to refinance from a 3% APR to a 7% APR.
READ MORE: Debt consolidation pros and cons
Option 5: Debt Settlement
- How it works: A third-party debt settlement company will negotiate settlements with the creditors of your unsecured debts. You will pay a fee ranging from 15% to 27% of your total enrolled debt.
- Advantages: You will pay off those debts for a fraction of what you owe, and you don’t pay any fees until settlements have been reached. Plus, debt settlement companies offer a free consultation, so it’s easy to learn whether you’re eligible without making a big commitment.
- Disadvantages: Your credit score will decrease substantially during the settlement process, but will rebound once you complete the program. Also, debt settlement only works certain types of debt, so secured loans like car loans and home loans can’t be settled.
READ MORE: Is debt settlement the fastest way to get out of debt?
Real World Example
Only unsecured debts are eligible for settlement, which means only the first four can be enrolled in a debt settlement program.
- Credit card debt 1: $3,000 balance at 20% APR, credit limit of $25,000
- Credit card debt 2: $10,000 balance at 14% APR, credit limit of $12,000
- Personal loan: $12,000 balance at 10% APR
- Medical bill: $2,000 balance at 8.75% APR, fixed monthly payment of $100
- Auto loan: $25,000 balance at 7% APR, you have missed two consecutive payments
- Student loan: $12,000 balance at 6% APR
- Home loan: $120,000 balance at 3% APR
Let’s say you enroll both credit cards and the personal loan in a debt settlement program. You would keep making payments on your medical bill, auto loan, student loan and home loan. You would stop making payments on your two credit cards and personal loan. Instead, that money would go to the debt settlement company, where it is placed in a designated savings account for you. As settlements are reached, that money is used to pay your creditors.
On average, debt settlement customers pay about 80% of the total amount they owe (counting the fees), so you’d end up paying about $20,000 to pay off $25,000 in unsecured debt, saving about $5,000 plus the interest you would have accrued during the payoff period.
READ MORE: Best debt settlement companies
Option 6: Create Your Own Repayment Plan
- How it works: You make your own plan based on your priorities and budget. You could try DIY debt consolidation by using a balance transfer credit card. Or you could try calling your creditors directly and asking for a lower interest rate.
- Advantages: This will have the lowest cost and most flexibility.
- Disadvantages: Unless you are extremely disciplined, it’s the least likely to be successful in the long run.
Real World Example
Let’s say your priority is to lower the number of minimum payments you have to make each month, but your credit score isn’t high enough to qualify for a debt consolidation loan. In that instance, you’d start with the medical bill and credit card debts, then move on to the personal loan. You could call the credit card issuers and ask them to reduce your APR to 10%, and the medical bill creditor to reduce your monthly payment to $50 due to financial hardship.
Before You Begin
Before you decide which option to pursue, you need to consider a few variables. The key to success is to choose the option that works best for your situation. What works for your friend or family member may not work for you.
Examine Income and Expenses
Are you spending more than you bring in each month? If so, you need to get your spending under control. Otherwise, any debt repayment plan is bound to fail.
Start an Emergency Fund
Stash some money in an emergency fund. Bryan M. Kuderna, a Certified Financial Planner and author of What Should I Do With My Money, says in his book that for people with no emergency fund, every unexpected event becomes an emergency. Stash away a small amount of money so that you don’t have to worry about taking on new debt if your car suddenly needs a new part or your air conditioner needs to be repaired.
Do You Have Medical Debt on a Specialty Credit Card?
If your medical bills aren’t owed directly to the provider, but instead are on a specialty credit card such as Care Credit, the repayment priority changes. Care Credit APRs can be fairly high – ranging from 17% to 20% APR. Treat those debts as though they were on a traditional credit card.
Are Your Student Loans Federal or Private?
The type of student loans you have makes a difference when it comes to repayment strategies.
Private Student Loans
If your student loans are private, factor them into your repayment strategy as though they were personal loans or credit card debt. Check your interest rate. You should prioritize repaying those or try to consolidate them to a loan with a lower interest rate. Private student loans tend to have higher interest rates and no government protections, so they likely are eligible for debt settlement and debt consolidation programs.
Federal Student Loans
You want to leave these alone and just keep making your minimum monthly loan payments. These have government protections (like the COVID-19 payment pause) that you would lose if you try to refinance, consolidate or settle these loans.
READ MORE: Different types of student loans
More Repayment Options
If you’re still uncertain about how to proceed, you still have a few more options:
- Consult a credit counselor: They will assess your needs and set up a Debt Management Plan on your behalf. Basically, you pay a nonprofit credit counseling agency a fee ranging from $20 to $80 per month to set up a repayment strategy and negotiate lower interest rates with your credit card issuer.
READ MORE: Debt settlement vs. debt management
- Bankruptcy: If you are truly overwhelmed, bankruptcy may be the fresh start you need. You may even be able to keep your car and home. Consult a bankruptcy attorney to learn more about your options.
READ MORE: Do I need an attorney for bankruptcy?
Learning How to Manage Your Debt is a Crucial First Step
Kuderna says that trying to build a solid financial foundation won’t be successful until you tackle your high-interest debts.
“It’s akin to adjusting a boat’s sails while the cabin floods with water,” he writes.
The Key is to Start Somewhere — Now
The option that will work best for you will depend on the types of debt you have, loan balances, discipline level and financial goals. But it’s important to take action immediately, before your situation worsens.
The Bottom Line
Repaying debt isn’t easy or pleasant. But you can ease the pain a bit by tackling your high-interest debt with the right repayment strategy. Choose the approach that works best for you, and stick to it. It may take a few years, but in the end you’ll be debt-free and that will make it worth the effort.
FAQs
Chapter 7 is known as “liquidation” bankruptcy. To qualify, you must pass the means test, which assesses your income and expenses. If your income is below the median income for your state or if you can demonstrate that you don’t have enough disposable income to repay your debts, you may be eligible for Chapter 7. Chapter 7 usually takes between three to six months to complete.
In Chapter 7, non-exempt assets may be sold to pay creditors. However, each state has its own exemptions that protect certain types and amounts of property from liquidation.
Chapter 13 is often referred to as “reorganization” bankruptcy. Instead of liquidating assets, you create a repayment plan to pay back your creditors over a period of three to five years.
Chapter 13 is available to individuals (not businesses) with a regular income who have unsecured debts less than $419,275 and secured debts less than $1,257,850. The process usually lasts between three to five years. In Chapter 13, you can often keep all of your assets, even if they would have been liquidated in Chapter 7, as long as you can afford to make payments under your repayment plan.
Learn more about the different types of bankruptcy.
Federal student loans are loans provided by the U.S. Department of Education. These loans are funded by the federal government. They typically have fixed interest rates that are lower than private student loans, and can be subsidized or unsubsidized. Federal student loans offer various repayment plans, including income-driven repayment plans that base your monthly payments on your income and family size. This flexibility can be helpful for borrowers facing financial challenges. There are also deferment and forbearance options and loan forgiveness programs.
Private student loans are offered by private lenders, such as banks, credit unions, and online lenders. They are not backed by the federal government. Interest rates can be fixed or variable and are typically based on your credit score. They may be higher than federal loan rates, especially if you have poor credit. Repayment options are less flexible and there typically are no forgiveness programs offered.
Secured loans are backed by collateral. This means the lender assumes less risk when issuing you a loan, because if you stop making payments, they will repossess the item that secures your loan. Home loans and auto loans are common types of secured loans. Unsecured loans don’t require collateral, so the lender assumes more risk. This means your credit score will be important. If your credit score is low, you’ll pay higher interest rates because there is no asset to seize if you stop making payments. Learn more about the differences.