When it comes to repaying debt, there are a few tips and tricks that will make your bills more affordable and your payments more effective. But first you’re going to have to train your brain to make savvy debt payoff moves.
“With any loan or debt, there’s the mathematical answer and the psychological answer,” says James Shagawat, president of Windfall Wealth Advisors in Paramus, New Jersey. Sometimes your emotions might cause you to want to pay off the loans that bug you most instead of the debt that’s costing you the most, so think carefully before deciding which debt to tackle first.
Here’s what to know about how to repay debt.
[See: What to Do If You’ve Fallen (Way) Behind on Your Credit Card Payments.]
Understand the definition of debt. What is debt? When it comes to your personal finances, debt is generally money borrowed from another party, often a bank or lender. As a consumer, you might use debt to finance a new home, a car or a college education. But not all debt is created equal. Some loans, such as mortgage or student loan debt, are considered “good debt” because they finance an investment — your house and education, for example — that will earn you money down the road.
Other debt, such as credit card debt, is considered “bad debt” because the purchases you’ve made will lose value over time. It’s often worth prioritizing the repayment of these value-losing loans, especially if they carry high interest rates, experts say. Loans with high interest rates can become very expensive as interest accrues, increasing the total amount you owe on the loan.
“Try to eliminate all debt, except anything tax-favorable or [debt] on an appreciating investment,” Shagawat says.
Know these tips to repay loans. Whatever you do, don’t ignore any debts you owe. “Ignoring your unpaid bills is the usually worst strategy for dealing with debt,” says Amy Loftsgordon, foreclosure, collections and debt management editor at Nolo, a publisher of do-it-yourself legal books and software, via email. “If you refuse to pay a debt, the creditor or collector will normally hound you for payment with letters and calls, as well as report — and continue to report — the delinquency to the credit-reporting agencies, which will severely damage your credit score.”
Ignoring debt will also allow fines and interest to accrue, sinking you further into the hole, Loftsgordon says.
One logical way to tackle debt is to take note of all your outstanding loans, writing down the remaining balances and interest rates, then direct any extra funds (after you’ve made the necessary minimum payments on all your loans) to pay down high-interest debt first. This is called the “debt avalanche” method. To remember how to do this, Shagawat recommends saying this rhyme:
“When the interest rate is low, pay it slow. When the interest rate is high, let the debt die.”
Some debtors, however, are motivated by “small wins,” which give them extra confidence to continue repaying debt. The “debt snowball” method encourages consumers to repay debt with the smallest balance first (after paying any necessary minimum payments on all outstanding debt). Once you’ve paid off an entire loan, you can move to the next one — then the next one and the next one. Paying off entire loans can certainly be motivating, but you’ll pay more overall in interest charges than you would under the “avalanche method.”
You may also want to focus first on high-priority debts, including those secured by collateral, such as a mortgage or auto loan, plus utilities, child support and federal student loans, Loftsgordon says. Ignoring those debts could result in a foreclosure, for example, having your electricity shut off or, in the case of student loans, having your tax refund garnished. After paying those debts, it makes sense to put money toward high-interest debt, such as credit card debt, she says.
Before putting any extra funds toward a paying down a debt early, confirm that there’s no prepayment penalty, Shagawat says. These penalties, typically outlined in your loan agreement, will cost you in fees when you repay your debt ahead of schedule, reducing any potential savings. Keep an eye out for these penalties, especially in your mortgage agreement.
Bottom line: The best debt-payoff method is the one you can stick with. Just like when choosing a diet or exercise regimen, you’ll have a better chance at success if you understand, and even enjoy, your debt repayment strategy.
[See: Should You Invest or Pay Off Debt?]
Remember the unique properties of federal student loans. The options for paying off student loan debt may differ from the options you have for paying off, say, credit card debt or a car loan. That’s because consumers who borrow through the Department of Education student loan system have access to repayment plans that tie their monthly bills to income and include debt forgiveness after a certain number of on-time payments. Private student loans, on the other hand, typically don’t include access to income-based repayment or other debt forgiveness options.
If you’re not sure what your options are for repaying your student loans, talk to your student loan servicer.
Be wary of debt relief and debt consolidation offers. If you’re struggling to repay debt, you may be tempted to work with a debt relief group or debt consolidation company. But you should think twice before working with one of these companies, debt experts say.
“Be skeptical about companies promising debt relief,” says April Kuehnhoff, staff attorney at National Consumer Law Center in Boston. “Consider how much you’re being asked to pay and what it is the company is actually promising.”
Loftsgordon says that debt relief companies often make this pitch: “We’ll collect monthly payments from you and put that money in a special savings account. Once we think there’s enough money in the account, we’ll contact your creditors and convince them to accept a lump sum for far less than you actually owe. We can probably settle your debt for half of what you owe, and you’ll be debt-free in 24 to 36 months.”
But what debtors don’t know is that a debt relief company may tell you to stop paying your creditors, worsening your debt problem as it hoards your money in its own account. Or it may simply offer a more expensive way to accomplish something you could have done on your own. At worst, it could run off with your money.
“Most people are much better off trying to negotiate debt settlements on their own, or filing for bankruptcy, rather than hiring one of these companies,” Loftsgordon says.
[See: 8 Financial Steps to Take After Paying Off a Debt.]
Consider bankruptcy. For some debtors, bankruptcy may be a better option than trying to settle their debts. “If you need help weighing the pros and cons of trying to settle your debts versus filing for bankruptcy, it’s a good idea to talk with a bankruptcy attorney,” Loftsgordon says. Keep in mind that bankruptcy comes with its own downsides, including staying on your FICO credit report for up to a decade.
You may also want to turn to an accredited, nonprofit credit counseling agency, Loftsgordon says. Start your search at the National Foundation for Credit Counseling, and remember to steer clear of debt relief companies. Says Loftsgordon: “A legitimate credit counselor can help you with budgeting, provide bankruptcy counseling and come up with a plan to help you avoid future financial problems.”
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Debt Repayment Guide: Everything You Need to Know About Repaying Loans originally appeared on usnews.com
