In the first quarter of 2018, total household debt increased by $63 billion. It was the 15th quarter in a row total household debt rose. Americans owed a collective $13.21 trillion at the time, including $1.41 trillion in student loans, $1.23 trillion in auto loans, and $815 billion in credit card debt.
All of these statistics make one thing clear: Americans owe a ton of money. Owing all this cash can become a big problem, as it can compromise your financial goals and even your health.
The good news is, you don't have to spend your life paying interest to creditors. You can make a solid plan to tackle your debt once and for all using the steps outlined here.
1. Understand How Debt Works
Before you can figure out how to get out of debt, you need to understand how debt works. When you're in debt, of course that means you owe money—but there's a lot more to know than that.
First, when you borrow money, you usually have to pay it back with interest. The amount you borrow is called the principal, and interest makes the principal balance grow. For example, if you borrow $100, you don't just pay back $100—you pay $100 plus interest. The specific amount of interest you're charged depends upon:
- Your interest rate, which is based on a percentage of what you borrow, such as 10% interest. Your rate could be fixed, which means it always stays the same, or variable which means it can change periodically. Variable rates are usually tied to a financial index, such as the LIBOR index.
- How often interest compounds. Compounding occurs when interest is charged and added onto the principal balance. If interest compounds daily, interest is charged every day and added to your principal balance. So, the next day, interest is charged on principal balance that's slightly higher. The more often your interest compounds, the higher your actual interest costs are. If you borrowed $100 at 10 percent interest and interest compounded daily, you wouldn't owe just owe $110 at the end of the year if you never made a payment. Each day, you'd owe 1/365 of the 10 percent annual interest. Your daily interest cost would be added to your balance, so you'd be charged daily interest on a slightly higher balance every day. At the end of the year, you'd owe $110.52.
- Your loan term. The longer you take to pay off your loan, the more you pay in interest, because you're charged interest for a longer time.
If the monthly payment on your debt isn't enough to pay off the interest that accrued during the month, you will literally be in debt forever. All the money you pay would go toward interest, and your principal balance would never go down. That's why it's important to make sure your payments reduce your principal each month as much as possible if you hope to become debt free.
Making extra payments should allow more money to come off the principal—so next month, you'd pay interest on a smaller principal balance and your interest cost would be lower. That's why paying extra can be so helpful in becoming debt free. Not only do you reduce the remaining balance owed, but you also reduce the interest cost that causes your balance to grow.
Making only small payments on your debt, on the other hand, can mean paying a fortune in interest—even if you can eventually pay off the loan. If you borrow $10,000 at 18% and take seven years to repay it, you'd pay $7,670 in interest. That's a lot of extra money you put into the pocket of a creditor instead of investing for your future.
2. Identify the Details About Your Debt
Step one in getting out of debt is to look at the big picture. That means listing every single debt you have, with details including the current balance, interest rate, and monthly payment.
Not sure where to find this information? Check your credit report for a complete listing of creditors. You can obtain a copy for free from annualcreditreport.com from each of three major credit reporting agencies. You're entitled to one report a year from each of the three major credit reporting agencies—Equifax, Experian and TransUnion—so you can space out your requests and get a report once every four months. Sign into online accounts for each creditor if you have them, look back at your most recent statement, or give your creditors a call to get the info you need.
If you owe certain kinds of debt, there are additional online tools to find out what you owe. The National Student Loan Data System allows you to search for student loans to find your servicer, interest rate, and amount due.
You can't get a handle on your debt without knowing the specifics, so getting the details is key to creating a debt repayment plan.
3. Determine if Debt Repayment Is Feasible
You may discover you owe so much—or that payments are so high—it's impossible to ever climb out of the hole. In these circumstances, throwing money at debt that won't ever be paid down doesn't make sense. Instead, it's time to explore bankruptcy or work out a plan with lenders to pay less than you owe.
Bankruptcy can't solve your problems if you have substantial student loan debt. Student loans aren't dischargeable in bankruptcy except in extreme cases where you can show severe hardship, such as becoming unable to ever work because of total permanent disability. You also can't get rid of mortgage or car loan debt if you hope to keep the assets; you'll need to become current and eventually repay these debts in full to avoid foreclosure or repossession of the vehicle. But for unsecured debt—which is debt not guaranteed by your assets that you simply promised to repay—bankruptcy could provide relief.
Negotiating a debt relief plan. Trying to work with creditors should come first before bankruptcy. Let the lenders know you aren't able to pay your bills and are thinking about filing for bankruptcy protection unless they're willing to work with you. The creditors may allow you to repay a portion of your debt—either in a lump sum or over time—and forgive the rest.
If you negotiate a payment plan or a settlement offer, get it in writing. And don't give creditors access to your bank account, as this could make it easier for them to get a court order to freeze your bank account or to put a lien on it—and unscrupulous collectors could take out more money than you give permission for. Instead, send payments in the mail.
A debt settlement plan in which you repay less than you owe hurts your credit. If your score is around 680 at the time you settle your debt, you could lose between 45 and 65 points. If your score was around 780, you'd lose between 140 and 160 points. However, it won't hurt your score as much as bankruptcy. For a 680 score, bankruptcy could take off 130 to 150 points, and for a 780 score, bankruptcy would cause a drop between 220 and 240 points. While the drop to your score is dramatic and it could take several years to recover, debt settlement could provide much-needed relief if you're struggling to pay bills.
There are companies that charge for help negotiating debt relief plans. Usually, it doesn't make sense to pay fees when you could call the creditor yourself to negotiate a plan. The key is, creditors won't usually work with you unless you're behind on payments and they fear they'll get nothing unless they agree to a deal.
Filing for bankruptcy protection. There are two types of personal bankruptcy: Chapter 7 and Chapter 13.
Chapter 7 bankruptcy allows you to discharge most debts, which means the debt disappears after bankruptcy proceedings. But there are strict income limits to be eligible—generally your income must be below the median in your state—and you might have to turn over some of assets to be sold so proceeds can be used to repay creditors. Your house, a very low-value automobile, and tools used for business are usually exempt from being sold.
Chapter 13 bankruptcy requires you to agree to a three- to five-year repayment plan with creditors. Any remaining balance owed on your debt after the payment plan ends is discharged or forgiven.
Bankruptcy stays on your credit report for a decade, it costs money, and it's emotionally difficult. It's a last resort—but it is an option you should often turn to before liquidating retirement savings (which is protected during bankruptcy) or before struggling for years to make payments on debt that doesn't go down because all the money goes to interest.
4. Save up an Emergency Fund
Before you get serious about paying extra money on your debt, you should have a mini-emergency fund of about $500 to $2,000. While eventually you should have an emergency fund equal to three to six months of living expenses, it might take a very long time to save that much money, and you may want to tackle higher interest debt repayment first.
But having this mini-emergency fund before devoting extra to your debt is vital to breaking the debt cycle. If you don't have some savings, you might find yourself trapped in a cycle you can never escape. You'll start paying off debt, and then your car breaks down, and you'll end up right back where you started with the same level of debt or more. This is discouraging, can cause you to get off track on repayment, and can make it impossible to ever make real progress.
When you have a small emergency fund, you won't have to reach for your credit cards when disaster strikes. You can use the saved money and not slide back into debt. Of course, when you use the money in your emergency fund, you may need to pause debt payment to rebuild it again. But at least you won't have gone deeper into debt when trying to climb out of the hole.
5. Decide Which Debt You Want to Pay Off Early
There are some types of debt that make sense to pay off ASAP. However, other kinds of debt fall into a gray area, and it may not make sense to put all your extra cash toward repayment—especially if you have other financial goals. Factors that you'd need to consider to decide whether to pay off a debt or not include:
- The interest charges: The higher the interest, the more important it is to pay off the debt ASAP.
- The amount owed: If it will take you a very long time to pay off the debt because you owe a lot, the opportunity cost of paying extra toward it instead of investing your money is greater.
- The loan terms: Some loans, such as federal student loans, have borrower protections in case of financial hardship or allow you to get loans forgiven for doing public service work. If a loan has favorable terms, it may not make sense to repay it early.
Some of the debts you may need to decide whether to repay include the following:
- Payday loans: These are short-term loans that charge very high fees. Often, you must give the lender access to your bank account or write a post-dated check for the loan amount. The check would be cashed on your next payday. Interest rates can be over 100 percent.
- Car title loans: Title loans are short-term loans, also with very high fees, that you guarantee by giving the lender the title to your car.
- High-interest credit card debt: Credit card debt is revolving debt; you charge as much as you want up to your credit limits and make monthly payments. The average interest rate on credit cards was close to 17 percent as of July 2018. Because credit card debt provides no benefit and rates are substantially higher than investments typically produce, aggressive early payoff is smart.
- Personal loans: Personal loans are for a fixed amount of money from banks, credit unions, and online sources. Average personal loan rates range from 10 percent to 28 percent, depending on credit. When rates are very high, early and aggressive debt payoff is important. If rates are reasonable, you may wish to prioritize other money goals before putting extra money toward repaying early.
- Medical debt: This is debt owed to providers, collectors or medical financing companies for healthcare services. Rates can vary dramatically. If you're on a low- or no-interest payment plan, investing instead of repaying debt early may make sense. If you're paying high interest, aggressive early payoff is smart.]
- Auto loans: Auto loans are secured debt guaranteed by your vehicle. For 60-month auto loans, the national average interest rate was 4.21 percent as of July 2018. Rates are low, so early payoff doesn't always make sense. However, it's a bad idea to continually have a car loan, so paying off the debt early and saving your car payment to buy your next car in cash is smart.
- Student loans: The federal government and private lenders issue loans to cover education costs. Federal student loans generally have a low interest rate and important borrower protections. Working in a qualifying public-service job entitles you to loan forgiveness after 120 on-time payments. Income-based payment plans also cap payments and allow a portion of your loan to be forgiven. While private student loans don't come with all these protections, rates may still be relatively low. And if your income is below $80,000 as a single or $165,000 if married filing jointly, you can deduct up to $2,500 in student loan interest from your taxes. Because of these perks, you may not want to pay off student debt early.
- Mortgage debt: Banks, credit unions, and online lenders provide secured loans to buy properties, which act as collateral. Mortgage debt is low-interest debt that comes with the ability to deduct interest on mortgages up to $1 million if you purchase your home before December 2018 or up to $750,000 if you purchased your home after the Tax Cuts and Jobs Act passed.
There's also an important caveat: You need to determine if the lender you're thinking about repaying charges a prepayment penalty for early payoff. Some personal loans, auto loans, and mortgages charge if you pay off your debt before the designated time. If so, you may not want to put that debt on your early payoff list, as any money saved on interest might be lost to the penalty.
6. Consider Refinancing Your Debt
One way to reduce the cost of debt is to finance it again. While most people think of refinancing as something you do with your mortgage, you can refinance virtually any type of debt by taking out a new loan—at a more favorable rate—and using the proceeds to repay other money you owe.
By lowering your interest rate, more of your payments go toward principal, so debt gets paid down faster.
Take the example of the $10,000 in debt at 18 percent. If you could lower the rate to 9 percent and it still took seven years to pay back what you owe, you'd pay only $3,511 in interest.
Even better, when you refinance to a lower-rate loan, it lowers your monthly payment. You could continue to pay the higher payments you were making before the refinance to get debt paid off on an accelerated timeline. That $10,000 at 18 percent over seven years would have monthly payments of around $210 monthly. If you refinanced to a 9% loan with a seven-year repayment period, the required payment would drop to $161. But if you kept paying the $210 you were paying before, you could repay the loan in just five years and pay only $2,418 in interest. You'd make payments for two years less and save yourself $5,252 in interest.
There are a number of ways you can secure new financing to repay existing debt. Let's look at some of them.
Credit card balance transfers. One of the simplest and easiest ways to lower the interest rate on credit card debt is to make credit card balance transfers. When you transfer a balance, you take advantage of a credit card offer that provides a low promotional rate for a limited period. It's common for credit cards to offer 0 percent interest on balance transfers for anywhere from 12 to 18 months. Balance-transfer cards sometimes charge a fee, such as 3 percent of the amount transferred, but there are some cards that don't impose charges, and those can be an especially good deal.
When you take a balance transfer, you'll move the balance on an existing credit card that's at a high interest rate over to the card with the 0 percent promotional rate. From that time on, you'll pay no interest for 12 to 18 months, or whatever the time limit on the promotional rate is. Every dollar you pay toward your debt goes to reducing the principal. You'll repay debt much more quickly when you have no interest to pay.
In some cases, credit card companies allow you to use balance-transfer checks. Essentially, you'll be able to deposit money in your bank account and get the special promotional balance transfer rate of 0 percent interest for a designated time. If you take advantage of this offer, you'd still pay whatever fee the card imposes for balance transfers, if any. This approach allows you to use a balance transfer to refinance even non-credit card debt to the 0 percent promotional rate. Just be careful not to confuse balance-transfer checks with a cash advance, which involves having your credit card lend you cash at a very high interest rate.
The interest rate on balance transfer credit cards often jumps up substantially after the promotional period expires, so this approach is best if you plan to repay the debt within the designated time the promotion is in effect. Otherwise, consider transferring the balance again after the promotional period expires to keep rates low.
Personal loans. Personal loans are another solution to refinance debt. You can take out a personal loan to repay credit card debt, medical debt, payday loans, or other types of high-interest debt. Many personal lenders do forbid you from using the proceeds of your loan to repay student debt, but otherwise you have almost endless flexibility in what you can use the borrowed money for.
Personal loans are available through banks, credit unions, online lenders, and peer-to-peer lending networks such as Lending Club and Prosper. The interest you'll pay varies depending upon the terms you qualify for. If you have better credit, the rate will be lower. Rates are almost always lower than credit card interest.
You can choose between a fixed or variable rate personal loan. A fixed rate loan ensures you have a set payment during the entire time you're repaying the debt. With a variable rate loan, you may start with a lower promotional rate but your rate and payments could possibly rise.
When you borrow using a personal loan, you'll have to repay the loan in a designated number of years, as determined by the loan agreement. The shorter the loan term, the higher your monthly payments and the lower total interest you'll pay.
Life insurance policies. If you have a cash value life insurance policy, you may be able to borrow against the policy to pay back debt.
There are big benefits to this approach. You don't have to go through an approval process—the amount you can borrow is determined by your policy's value. You can use the money to repay any debt you want, because there's no explanation required for what you plan to do with it. And while you need to pay back the policy with interest, you're borrowing from yourself so you aren't fattening the pockets of a creditor. Furthermore, there's typically no mandatory minimum monthly payment, and interest rates are low.
There are, however, some downsides. If you die before the loan is paid back, your beneficiaries receive less money, because the outstanding balance of the loan—including interest—is taken out of the death benefit. Plus, since interest is added to the loan's balance if you don't make monthly payments large enough to cover it, the amount you owe could grow to exceed the cash value of the policy and cause the policy to lapse. This could lead to a big tax bill, as you'd have to pay taxes on the cash value of a lapsed policy.
401(k)s. Taking a 401(k) is another option for debt repayment, if you have this type of retirement account. Typically, the maximum you can borrow is the lesser of 50 percent of assets in the 401(k) or $50,000.
As with a loan against your life insurance, you're borrowing from yourself, so there's no approval process and you can use the money to repay any debt you'd like. And interest—which is charged at a low rate—is paid to yourself. Payments are based on a five-year repayment schedule, but you could pay the loan back early without penalties.
The big downside is, if you need to leave your job for any reason, including if you're terminated, you must pay back the 401(k) loan quickly–often within 60 days. If you don't, the unpaid loan is treated as a taxable distribution and you'd have to pay a 10 percent penalty. Not only can a 401(k) loan trap you in your job, but you could also hurt your retirement savings goals, because you'll have less money invested and growing.
Home equity. Another way to refinance your debt is to tap into your home equity to repay what you owe. If you have equity in your home—that is, you owe less than your mortgage balance—you can get money out of your home using a home equity loan or a home equity line of credit. You could also refinance your entire mortgage and do a cash-out refi wherein you get a new loan to repay your old mortgage and give you extra cash in the process.
- Cash-out refinance loans involve borrowing enough to pay off your entire mortgage and receive some cash back.
- Home equity loans involve borrowing a fixed amount of money based on the equity in your home. As a simplified example, if your home is worth $100,000 and you owe $50,000 on it, you might be able to borrow between $30,000 and $40,000 in equity. Most home equity loan lenders won't allow you to borrow so much that you owe more than 80% to 90% of the value of the home.
- A home equity line of credit allows you to borrow up to a certain amount of money, but you can borrow as much or as little of the line of credit as you'd like. You're required to pay off all that you borrowed before a designated repayment date or if you sell the property.
The process of refinancing a home mortgage or taking a home equity loan or loan of credit is cumbersome, as you'll probably have to pay for a home appraisal to prove your home's value and may have to pay costly closing costs associated with obtaining the loan.
There's also a substantial risk associated with taking out a loan on your home, because the house secures the loan. When you owe unsecured debt, such as credit card debt, personal loan debt, or medical debt, there's nothing guaranteeing the loan except your promise to repay it. While lenders could sue you for unpaid debt and perhaps get an order to garnish wages or put a lien on your house, it's very unlikely your home could ever be put at risk of a forced sale because of unpaid unsecured debt. But when you've borrowed against your home, the house is collateral, and if you don't pay, the lender will probably foreclose and take the house. Converting unsecured debt to debt secured by your home isn't typically advisable for that reason.
The benefit of borrowing against your home, however, is interest rates will be much lower than for most other types of debt. And you may be eligible for a tax deduction for mortgage interest. However, with a home equity loan or a home equity line of credit, you're eligible to deduct interest only if the proceeds are used to pay for qualifying home improvement expenses.
Debt consolidation. When you refinance debt, you can often consolidate debt in the process, because the new loan is used to pay for multiple other debts. For example, if you had three credit cards on which you owed $3,000, $5,000, and $2,000 and you took a $10,000 balance transfer or personal loan to pay off all three, doing so has the effect of consolidating your debt.
There are also specific debt consolidation loans available, marketed to borrowers looking to get a handle on debt. In many cases, however, these debt consolidation loans have high interest rates and other unfavorable terms. If you see a loan product labeled as a debt consolidation loan, research very carefully to determine whether the loan is actually a good deal.
And don't assume a lower payment is always better. If a debt consolidation loan reduces your monthly payment but causes you to pay back the debt over a much longer time period, you could end up paying more in total interest.
Student loan consolidation. While debt consolidation loans often aren't worth it, there's a possible exception to this when it comes to debt consolidation for federal student loans.
The federal government allows you to consolidate eligible federal student loan debt from multiple loans into one big loan for convenience. Doing so will not lower your interest rate—the new rate on the consolidation loan is determined by a weighted average of debt you're consolidating—but it makes sense if you have many loans from multiple years of school and keeping track of all of them is difficult.
Consolidating student loan debt can also make it possible to get more borrower protections. For example, while Parent PLUS loans aren't eligible for income-based repayment, when these loans are consolidated under the Direct Loan program, they can become eligible. Income-driven repayment programs can result in a lower monthly payment and open up the door to loan forgiveness after a sufficient number of payments are made.
7. Choose a Debt Repayment Strategy
Whether you've consolidated or refinanced debt or not, you'll need a strategy for repaying the money you owe. If you have only one single big debt, the strategy is easy: Throw all the extra money you can at the loan until it's paid off.
But most people have multiple debts. If that's the case, you'll have to decide what order to repay the debt in. There are a few debt repayment strategies to choose from: the debt snowball, debt avalanche, and debt snowflake.
Debt snowball. The debt snowball idea was made popular by Dave Ramsey, who hosts radio shows and writes books on personal finance. The strategy involves paying off your loan with the lowest balance first, then the loan with the next lowest balance, and so on until all debt is repaid.
When using this strategy, you make minimum payments on all loans and then pay as much extra as you can toward the bill you're focused on repaying in full. Once that debt is paid off, add the payment you were making to the minimum payment for the loan with the next lowest balance, and so on.
For example, say you owed $1,000 on a credit card with a $100 minimum payment, $3,000 on another credit card with a $300 minimum, and $5,000 on a personal loan with a minimum payment of $250.
You'd make the minimum payments on all debts, and pay as much extra as possible toward the $1,000 credit card balance. Once that was paid off, the new "minimum" payment for the card with the $3,000 balance would be $400 (the original $300 minimum plus the $100 minimum you used to make on the card you paid off). Extra cash would also go to repay that card. Finally, once both of those were paid off, you'd focus all your attention on the personal loan. The new "minimum" payment would be $650 ($300 + $250 + $100).
The big advantage of the debt snowball is scoring quick wins. Science backs up the idea that this is the best approach, because you'll stay more motivated as you see debt balances paid off. But there's an obvious downside: Your smallest debt may not have the highest interest rate. If you're waiting longer to pay off high-interest debt while focusing on lower-rate debts, you'll pay more interest over time.
Debt avalanche.The debt avalanche is a twist on the debt snowball. Instead of paying extra on your lowest debt to get that paid off ASAP, you pay extra on the loan with the highest interest rate. When that loan is paid off, pay more on the debt with the next highest rate, and so on until all debt is paid. The big benefit: You save a lot of money by getting rid of high-interest debt first. The downside is, it may take you much longer to pay off your highest-interest debt than your loan with the lowest balance. And it's harder to stay motivated if you don't see debt disappear.
There are tricks you can use to stay on track if you need them. You could make a visual "debt thermometer" you color in as you get closer and closer to repaying your debt. Or you could make a paper chain, with each link representing a certain amount of the debt. Remove a link each time you make a payment.
The debt avalanche undeniably makes the most mathematical sense—you can use a calculator to input your debt information and see how much you'd save using this approach compared with the debt snowball. But if you have a hard time following through on your plans to be financially responsible, the debt snowball may still be a better approach.
Debt snowflake. The debt snowflake technique can be used in conjunction with either the debt avalanche or debt snowball. It simply involves making small payments on your debt every time you're able to save money over the course of your daily life.
For example, if you're snowflaking and you normally spend $5 on lunch at work and you pack your lunch and save that $5, you'd make a $5 payment on your debt right away. With the ability to make payments online for most loans, this process is easy and makes a lot of sense, because you're making effective use of savings right away.
8. Make a Budget and Automate Your Process
When you've made a plan to repay debt, it's ideal if you can automate payments so you don't have to force yourself to do the right thing every week or every month.
If you've decided to pay an extra $200 on your credit card for a total payment of $300 monthly, set up an automatic payment of $300 for the day you get your paycheck. The money will always go where you need it to—before you end up spending it—so if you have a month where you aren't super motivated, you won't get off track.
To make sure you can afford to do this, you'll probably need to make a budget.
Becoming Debt-Free Is Worth It
Paying off debt requires sacrifice and careful financial planning. But when you finally make that last payment and no longer owe any money, it will all be worth it in the end.