Three ways to get out of debt
Transcript of the video:
Upbeat music plays throughout.
Narrator: If you feel overwhelmed by debt, you're not alone.
On-screen text: Source: Board of Governors of the Federal Reserve System
In 2019, the average American owed more than $6,200 in credit card debt.
One of the biggest challenges of getting out of debt is knowing where to begin. Having a specific method can help.
On-screen text: Avalanche method, snowball method, and consolidation method.
Narrator: Here are three strategies to manage debt, especially debt with an interest rate higher than 5%: the avalanche method, where you pay off the debt with the highest interest first, the snowball method, where you pay off the smallest balance first, and consolidation, where you combine your debt.
We'll walk through each method to help you determine which one may be right for you. While it may require some sacrifices, it is possible to dig yourself out of debt.
Let's say you have debt on four different credit cards.
Animation: Credit card balances to include $1,300 with a 19% interest rate, $4,500 with a 14% interest rate, $15,000 with a 15% interest rate, and $9,200 with a 22% interest rate.
Narrator: To start, write down all of your outstanding balances and the interest rates on each.
On-screen text: Disclosure: Minimum monthly payment calculated as 2% of the total balance for this example. Your credit card's minimum payment may vary.
Narrator: Based on these totals, if you only paid the minimum on each card, you might not be debt free for almost 12 years.
Animation: Money is going toward the credit card with the $9,200 balance and 22% interest rate and paying the card off in full.
Narrator: With the avalanche method, you'll prioritize paying off the debt with the highest interest first. The idea is by focusing on the most expensive debt first, you'll save money over time.
For the other cards, pay the minimum every month, then put everything else you can toward paying off the highest interest rate card.
After the highest interest rate debt is paid off, you'll apply those payments to debt with the next highest rate, and so on.
The avalanche method will save you more money in interest payments than if you were to pay off lower interest debt first, so mathematically, the avalanche method is a better way to pay off debt.
Animation: Comparison of paying an extra $500 per month toward debt with an accumulated interest of $7,526 opposed to paying the minimum payment with an accumulated interest of $28,243. A difference of $20,717.
Narrator: If you're able to put an extra $500 per month toward this debt, the avalanche method could save you more than $20,000 in interest compared to just paying the minimum. It'd also shorten the life of your debt to only three years.
But for some, avalanches have to start somewhere—maybe as a snowball.
With the snowball method, you'll pay the minimum of all your balances and then put anything left toward the debt with the smallest balance first.
Animation: Four credits cards with different credit card balances to include $1,300 with a 19% interest rate, $4,500 with a 14% interest rate, $15,000 with a 15% interest rate, and $9,200 with a 22% interest rate.
Narrator: So, in this example, you'd pay off the $1,300 debt first.
It may seem financially unwise to pay off anything but the highest interest debt first, but with the snowball method, you're able to pay off a higher portion of one of your balances with each payment.
Animation: Two credit cards are compared. One with $1,300 in debt with a 19% interest rate and the second with $9,200 in debt with a 22% interest rate.
Narrator: Take that $1,300 debt: A $500 payment would pay off 38% of that account, while $500 toward the debt with the highest interest rate would only be 5% of that account balance.
A study in the Journal of Consumer Research found that when subjects paid down a higher portion of a balance on their debt, they were more motivated to keep going. Though it's not the most cost-effective method, in the long run, it was more effective.
Don't underestimate the power of psychology. The sense of accomplishment from completely paying off one balance can motivate you to stay disciplined with the others.
A third strategy for managing your debt repayment is consolidation.
Animation: Four credits cards with different credit card balances to include $1,300 with a 19% interest rate, $4,500 with a 14% interest rate, $15,000 with a 15% interest rate, and $9,200 with a 22% interest rate are all consolidated into one loan.
Narrator: This is combining all your debt into one, so you can make a single monthly payment, ideally, one with a lower interest rate than your existing accounts.
One way to consolidate debt is to take out a new loan or line of credit to pay off your existing debt.
Another choice is a balance transfer, which means moving your balances onto a new credit card. This may be a good idea if you're able to open a new credit card that offers 0% interest on balance transfers.
But typically, this 0% interest is only for a limited time, like a year or 18 months.
Animation: New combined interest rate of 10% compared to current combined interest rate of 17%.
Narrator: So, don't transfer your balances unless you're sure you can pay them off during this introductory period or if the new interest rate will be lower than your current combined interest rate.
In our example, if you combined everything into a 0% balance transfer for 12 months, you'd face payments of $2,500 per month. That's pretty steep, so make sure you're able to handle that amount, or you'll face interest at the end of the intro period. Once it's paid off, keep it that way. Pay your total balance monthly and manage your debt; don't let your debt manage you.
To review, avalanche saves money by paying debt with the highest interest rate first, snowball may maximize motivation by paying the smallest balance first, and consolidation may be useful if you can afford to combine all your debt into one payment.
There isn't one right way to dig yourself out of debt. Your numbers may be different than the ones we used in our example, which means the difference in total payoff could vary from one strategy to the next.
The most important thing is to stop adding to the debt, determine exactly how much you owe, pay as much toward it as you can, and stick to it.
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