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Debt can feel like a heavy weight, but there are several strategies you can use to lighten the load. These strategies aren't one-size-fits-all, and the best way for you to pay off debt depends on the amount and type of debt you have and your financial situation. Read on to learn more about your options for whittling down debt.
How to Choose a Debt Payoff Strategy
Choosing a debt payoff strategy doesn't have to be a tough task. To help you decide on the best payoff plan for your needs, take the following steps:
- Review your credit report to find out exactly what debts you owe. Make a list of your debts, including the interest rate, total amount owed and minimum monthly payment for each account.
- Check your credit score. Certain strategies may be better suited for you depending on your credit history.
- Calculate how much money you can afford to put toward paying off your debts.
- Create a budget to monitor your income and expenses. This should help you stay on track with whichever strategy you choose.
- Consider the various debt payoff methods you can adopt (see below), and figure out which ones would work best for your situation.
The Best Ways to Pay Off Debt
Consider these three common methods for paying off debt: debt consolidation, snowball strategy and avalanche strategy. These are best used to pay off high-interest non-mortgage debt such as credit cards, but can be used for other loans as well.
How debt consolidation works: With debt consolidation, you combine several small debts into one larger debt. This allows you to make one payment a month toward your debts, ideally at a lower interest rate. You can consolidate debts using a lower-interest debt consolidation loan or a balance transfer credit card with an introductory 0% APR.
Who debt consolidation is best for: Debt consolidation is best for people who have good credit scores. To qualify for a debt consolidation loan or balance transfer credit card, you typically need a credit score that at least falls in the "good" category, which is 670 or above in the FICO credit scoring model. A good score can also help you get favorable terms and a low interest rate.
Debt consolidation is the most helpful for someone who has high interest debt and is able to obtain a low interest rate that will decrease the amount of money going toward interest charges.
Debt Snowball Strategy
How debt snowball works: The debt snowball strategy involves paying the minimum amount due on your debts each month and then applying the extra money gained from making lower monthly payments to the credit card or loan with the smallest balance. After you've wiped out that debt, you reallocate the extra cash you were putting toward that debt to the debt with the next smallest balance. You'll repeat this process until all your debts are paid.
Who debt snowball is best for: The debt snowball strategy is best for people who might find it difficult to stay motivated to pay off debt. Because this method relies on paying off the smallest debt and working up to the largest, you can see progress in a short period of time. However, you're likely to accumulate more interest expenses with the debt snowball strategy than you would with other strategies.
Debt Avalanche Strategy
How debt avalanche works: When you follow the debt avalanche strategy, you start by paying off the debt with the highest interest rate, then work your way down to the debt with the lowest interest rate. With this method, you make minimum monthly payments on your debts and assign any surplus cash to the highest-interest debt. You stick to this method until all of your debts are gone.
Who debt avalanche is best for: If you're uncomfortable carrying a lot of high-interest debt, the debt avalanche strategy might be ideal for you. In the long run, this method can save you some money in interest charges. But keep in mind, you may not achieve as much payoff success early on compared with the debt snowball method.
How Paying Off Debt Affects Your Credit Score
Aside from providing a sense of relief when bill-paying time comes around each month, paying off your debt can improve your credit score.
Your credit score might not benefit from debt payoff for a few months. That's because it takes some time for paid-off balances to be reported and then factored into your credit score. Still, reducing debt—particularly credit card debt—eventually should lead to a bumped-up credit score, as long as you're being responsible with all of your credit accounts.
Keep in mind, though, that your credit score could drop if you pay off a credit card and then close that account. When you shut down a credit card account, you reduce the amount of available credit you have, which can cause your credit utilization ratio to increase and hurt your credit score.
Your credit utilization ratio refers to the amount of revolving credit (like credit cards) that you're using compared with the overall credit limit. As a rule of thumb, you should keep this ratio below 30% to avoid doing extra damage to your credit score, but the lower your utilization, the better. Credit utilization represents as much as 30% of your credit score, so it's an important factor to consider.
In a situation in which you pay off a credit card debt, it could be better to keep that card open but use it sparingly so that you can benefit from its credit limit without adding to your debt.
The Bottom Line
The ideal debt payoff strategy is the one that best fits your financial situation. For instance, if you're eager to achieve progress quickly, you might choose the debt snowball strategy over the debt avalanche strategy. Or if you have a high credit score and could qualify for a low-interest consolidation loan, that might help you save the most money while you work to pay off your debt.
Whatever strategy you settle on, it's important to monitor your credit, which you can do for free with Experian, so you can celebrate the step-by-step progress of paying off your debts.