Here are 6 ways to get back into the black faster
As the economy slowly improves, Americans are racking up more debt. And experts say they often make big mistakes when trying to shed that debt and get back into the black.
When people sense that they’re in a financial squeeze, they start putting Band-Aids on the problem, experts say. Debt settlement and bankruptcy should only be considered when you’ve run out of all other options. And some accepted norms for paying off debt, such as paying off the biggest debt first, may not always be the best way to go, according to a study published this month in the “Journal of Marketing Research.” Debt-laden consumers can be burned out trying to pay off larger amounts with higher interest rates – even though such a strategy makes more financial sense on paper. (Read: “Financial pros have been getting this wrong for years.”)
“American consumers de-leveraged after the financial crisis, but they’re starting to take on more debt again,” says Ben Woolsey, president of credit-card advice website CreditCardForum.com. Total outstanding revolving credit card debt reached $870 billion at the end of June 2015, according to the latest data from the Federal Reserve, up from $848 billion in the first quarter of 2015. The average American household holds around $15,863 in credit card debt, $156,584 in mortgage debt and $33,090 in student loan debt, according to Federal Reserve and government data crunched by personal finance site NerdWallet.com. All told, Americans owe around $11.86 trillion in debt, up 2% from last year.
People who are mired in debt often make rookie mistakes, especially as many panic, says Kathryn Davis, president and CEO of BALANCE, a subsidiary of the non-profit Consumer Credit Counseling Service of San Francisco. Some no-nos: Taking out a payday loan or title loans; transferring a balance to a new zero-interest credit card, but failing to pay off the balance when the higher interest rate kicks in; and borrowing from a 401(k) retirement account, especially if it involves paying a penalty. Putting creditors on rotation — paying one creditor while failing to make payments on other debt — is another bad idea: After six months, no one will be happy.
Here are 6 smarter (and faster) ways to pay off debt:
Prioritize payoffs based on interest rates
Notwithstanding the psychological benefits of paying off a small loan outlined above, it may also make sense to concentrate on paying off the credit card with the highest interest rate first, while making smaller or even just required minimum payments on their other debt accounts, says Lindsay Konsko, user operating analyst at NerdWallet.com. Do the mathematics to see how much will be ultimately paid on each card with interest. “Most people will save paying off the highest interest rate first,” she says, though “it’s a judgment call on the consumer’s part.” (This couple cleared $125,000 in debt over four years; they decided to pay off the lowest dollar amount on each credit card first because it gave them a greater sense of achievement.)
Treat your debt plan like a diet plan
“Paying off debt is like getting in shape and losing weight,” says Ben Barzideh, financial adviser at Piershale Financial Group in Crystal Lake, Ill. Both require discipline and little treats along the way, and both should target the one area that bothers you the most. “Make a to-do list, track your monthly inflows and outflows just like calories,” Barzideh says. And Konsko recommends little rewards when you reach debt milestones, like a $10 manicure or book when you pay off $1,000 in debt. As with a diet, make sure your debt repayment plan is not unrealistic. There’s no point in giving up halfway through and going on another spending splurge. “People who want to lose weight say, ‘I’ll never eat another chocolate cake,’ but they can usually do it for [only] a short amount of time,” says Lynnette Khalfani Cox, author of “Zero Debt: The Ultimate Guide to Financial Freedom.”
Don’t miss any payments
If you are overwhelmed by your credit cards or car loan, but haven’t yet missed a payment, make sure you don’t. Becoming a problem won’t endear you to the credit card companies, Khalfani Cox says. She’s speaking from experience: In 2001, she owed $100,000 on credit cards, and she paid them all off within three years. She says she had one advantage. “I hadn’t missed a payment in 20-something years,” she says. This track record helped her negotiate double-digit interest rates to single digits, in one case cutting an interest rate to 4.9% from 16%. “A bank would rather get some interest from you than get 0% by [you] defaulting,” she says.
Tread carefully around debt management and debt settlement
Know the difference between a “debt management” organization and a “debt settlement” company that offers legal and financial services, says Darryl Dahlheimer, program director at LSS (Lutheran Social Service) Financial Counseling in Minneapolis, Minn. The former category includes non-profit organizations that belong to the National Foundation for Credit Counseling, while the latter is made up of for-profit companies. Confusing the two could cost thousands of dollars.
Last year, Dahlheimer says, one of his clients heard about a debt settlement company on the radio. He was instructed to stop paying his creditors so the company could offer a reduced lump sum. He made seven payments of $400 a month, yet no accounts have been settled, and the company has charged him a $2,100 fee. “Unfortunately, this is common,” Dahlheimer says. Debt management programs aren’t completely seamless for consumers, either: When you enter a debt management plan, that fact can be reported to credit agencies, hurting your credit score. But when payments are made on time through a program, that can also help rebuild credit scores.
Student loan forgiveness for public employees
Student-debt holders who work in public service, for the government or a non-profit, or who want such a job, should find out whether they’re eligible for debt forgiveness. Under the government’s Public Service Loan Forgiveness Program, borrowers in public service jobs may qualify for forgiveness of the remaining balance of their Direct Loans after making 120 qualifying payments on those loans. (Direct Loans are so-called because the loan comes direct from the Department of Education.) A person with $150,000 in federal student loans at 6.875% with a $40,000-a-year job who owes $281 a month in student-loan payments could save $321,000 in principal and interest payments by committing to public service for 10 years, says Demetrios Sourmaidis, CFO at StudentDebtRelief, which counsels borrowers on student loan programs. “People are empowered when they know their options.”
Refinance debt to get lower interest rates
“People compartmentalize debt,” says Kenneth Lin, CEO of personal finance site CreditKarma.com. “They think of mortgage debt as very distinct from their credit cards and auto loans.” Even auto loans can be renegotiated. He suggests consolidating your loans, but only if you can do so at a lower interest rate. Your home loan could also help you manage your other debt. Most mortgages have an interest rate of 5% or less, while student loan debt might be closer to 8%, auto loans could be as high as 7% and credit card debt could range from the teens to 20% or more. It might be worth paying off hefty credit card bills or unexpected medical debt by borrowing money against your home through a home-equity loan refinancing (you can do this if you’ve built up equity in the home). But only do this if you’re 100% sure you’re not putting your home at risk, he warns.
This story has been updated.
Quentin Fottrell is a personal finance reporter for MarketWatch based in New York. You can follow him on Twitter @quantanamo.
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