If you’re overwhelmed with debt, you are not alone. The average American family has $123,400 in debt, according to the Federal Reserve’s latest Survey of Consumer Finances.
The lion share of consumer debt is made up of mortgage loans (68%). However, student loans (10%), auto loans (9%), and credit cards (6%) still amount o an average of $12,250 per person.
This is not ok. Just because debt is common, doesn’t make it acceptable. Everybody’s number one financial goal should be to get out of debt.
Our goal is that you become debt-free as fast as possible. The following steps and tools will help you get there.
Step 1: Take time to get a handle on your financial situation
For many, this is the hardest step in our guide. After all, who has time to sit down and create a budget. Unfortunately, there is no way around it. To start, create a simple spreadsheet with a row for each creditor. Include auto loans, student loans, mortgages, credit cards, and any other source of debt. Include the balance you owe, the interest rate you’re charged, and the monthly payment. If it’s a credit card, include the minimum payment. In the last column, specify whether the debt is secured or unsecured. For example, a mortgage is a secured debt because the bank will take your home if you don’t make payments. Credit card debt, on the other hand, is unsecured debt.
The list may look something like this:
If you’re not sure about the balances in all your accounts, check your credit report. It will have a list of all the creditors that report to the credit reporting bureaus. The balances on your credit report may not be 100% accurate. Once you have a list of creditors, confirm the balances with them. Now you know the extent of your debt and the money you have available to pay it off, you have some serious decisions to make.
Although it is possible to do it all by yourself, some people benefit from talking to a professional personal finance counselor at this stage. If you think you could benefit from a better understanding of how to budget, improve your credit, and reduce your debt, consider hiring a credit counseling service, such as Consumer Education Services. Many of the budgeting and personal finance counseling services offered by these companies are free.
Step 2: Reduce and simplify your interest expenses
Consolidate unsecured debt
Debt consolidation allows qualified consumers to take out a new loan that pays off most or all their outstanding debt. The purpose of debt consolidation is to combine all your existing debt from various sources into one loan.
This means that you only have to pay one loan payment a month instead of several smaller loan payments. Ideally, debt consolidation loans should have a lower interest rate than the rates you are currently paying to help you get out of debt.
What options are available for debt consolidation?
It boils down to three main options. You can:
- Get a personal loan.
- Transfer all your other credit card balances to one card.
- Apply for a home equity loan or cash-out mortgage refinance.
If your credit isn’t where it needs to be to get approved for a balance transfer card, consider applying for a personal loan. You won’t get any 0% APR offers and the interest rate can be higher than that of a HELOC. But this alternative’s unsecured nature means you’re not risking any collateral.
A couple of things to keep in mind with personal loans:
- A lower interest rate isn’t guaranteed. Depending on your credit, you may not get approved for a loan. And if you do, the APR may even be higher than your credit card’s APR.
- Personal loans have a fixed repayment period and fixed monthly payments. Make sure you can afford the payments before accepting a loan.
Consolidating your debt can improve your credit score
Personal loans can also help improve your credit score. How? Well, 10% of your FICO credit score, the score most widely used by lenders, is based on your credit mix. Having a varied credit mix, such as personal loans, mortgage, and credit card accounts, can improve your credit score. Your credit utilization ratio on revolving accounts — your debt as a percentage of your available credit — is also an important factor when calculating your FICO scores. Moving revolving credit debt to a personal loan will lower your credit utilization ratio, which could improve your credit.
Purchasing a loan is like buying a used car. Prices vary wildly depending on whether you buy from a private owner or a dealership, as well as on the age, brand, and condition of the vehicle. Personal loans are also a highly competitive business where prices vary by provider. So get ready to kick some tires.
SuperMoney’s loan offer engine makes it easy to compare your options across many different lending partners without affecting your credit score. You can also research product details and company reviews directly on SuperMoney’s personal loan review pages.
Balance transfer credit cards
Consider switching your credit card debt to a 0% APR balance transfer card. If you have $15,000 in debt and an average 15% APR, you could save $1,940 in interest during just 12 months of 0% APR. Combine a 0% APR balance transfer with an aggressive repayment plan, and you could repay your entire credit card debt in less than a year.
Remember, balance transfers are not always free. The APR may be 0%, but APRs don’t include balance transfer fees, which can be as high as 5%. There are balance transfer credit cards, such as Slate, that don’t charge transfer fees, but these are rare. This doesn’t mean you shouldn’t transfer your credit balance. Make sure you take into account these fees when calculating the pros and cons of a balance transfer.
Home equity loans
A home equity line of credit is similar to a credit card in that you have a revolving line of credit that you can use, pay off, and use again. The difference is that most credit cards don’t require collateral, while a HELOC uses your home as collateral.
Because of this setup, HELOCs are considered secured debt and have relatively low – and usually variable – interest rates. To illustrate, the average APR for credit cards in 2018 was around 16%. The average APR for a HELOC was about 5%.
The obvious advantage of using a HELOC to pay off credit card debt is that you can consolidate at a lower interest rate, even if you have poor credit. Another reason HELOCs are appealing is that, like your mortgage payments, the interest you pay is tax-deductible.
However, there are serious drawbacks to consider. The worst that can happen if you don’t pay your credit is a damaged credit score. If you don’t make payments on your HELOC, you could lose your home.
Refinance secured loans
Refinancing your loans for shorter terms and lower interest rates can save you thousands of dollars and help you pay off your debt faster.
Mortgage debt represents 68% of American households’ debt. Imagine how much you could save if you lower your housing expenses by refinancing your mortgage. To illustrate, a 1% interest reduction on a 30-year $300k mortgage could lower your monthly payments by $178 and reduce the total cost of the mortgage by $64,000.
If you qualify for a mortgage refinance, consider a cash-out refinance to consolidate and pay off your other debts.
A cash-out refinance involves getting a new loan with a slightly lower interest rate for a larger amount than the existing mortgage loan. As the borrower, you receive the difference between the two loans in cash to use as you please. In this case, you’ll be using the cash to pay off your high-interest debt like credit cards, a car loan, or a personal loan.
For instance, say you own a home valued at $250,000 and still owe $150,000 on the mortgage. You’ll have built up $100,000 in equity. You need an extra $25,000 to pay off some credit card debt and a car loan.
You can get a cash-out mortgage refinance with a new loan for $175,000 ($150,000 loan you’ll still owe on your home via mortgage payments, plus $25,000 cash). With this strategy, you can consolidate debt into a home loan and pay it off at a much lower interest rate.
Compare rates and terms from top mortgage refinance lenders now.
Student loan refinancing
The average debt of a four-year college student is $26,830, according to the Federal Student Aid Office. For some graduates, that could amount to more than half of their starting salary.
If you’re looking for ways to relieve the burden of your student debt, considering refinancing your student loans. You may qualify for lower interest rates if your student loans are older or if your credit has improved.
Compare the top student loan refinancing lenders to see which one offers the best feature combination for your needs.
Auto loan refinancing
If you decide to refinance your car loan, it can save you money and possibly reduce the length of the loan. SuperMoney’s auto loan offer engine makes it easy to compare the rates and terms of the top auto refinance lenders.
Say you owe $20,000 on your auto loan at 7% interest, and you’re paying $300 per month for the next 85 months, you’ll pay $5,401 of interest over the life of the loan. Here are interest reduction scenarios for comparison. Keep in mind–these loan refinancing scenarios are examples and don’t include any taxes or extra fees.
- Lower your rate to 5% interest and your monthly payments will drop to $280, saving you a total of $1,702.
- Reduce the interest rate to 4% and the monthly payment will be $271, saving you a total of $2,490.
- A reduction to 3% interest will lower the monthly payment to $261, saving you a total of $3,262.
Step 3: Choose the best payment method for your situation
All debt payment methods boil down to two main strategies: the snowball method and the highest rate first or avalanche method.
Pay the highest interest rate first
This method works by organizing your debts by their interest rate. Identify the account with the highest APR. Make minimum payments on all the other accounts and pay off as much as can toward the account with the highest APR. This method is also called the avalanche method. If you don’t qualify for a 0% APR balance transfer card, this is probably the best way to reduce interest payments while getting out of debt.
The snowball method requires you to pay as much as you can on your smallest debt while making minimum payments on the other ones. Once it’s paid, go on to the next smallest debt until you are debt-free. This method will probably cost you more in interest, but it has the advantage of providing quick wins, which could help you stick with the debt repayment plan.
Snowball vs. avalanche: which debt payment is best?
Let’s use an example to compare both methods. Imagine you have three credit card accounts:
Card #1 has a balance of $5,000 and a 13% APR
Card #2 has a balance of $8,000 and a 20% APR
Card #3 has a balance of $2,000 and a 12% APR
If you can afford to make $800 in monthly payments and follow the debt avalanche method (i.e. pay off the account with the highest interest first), you will pay $2,226 in interest and be debt-free in 1 year and 11 months.
Use the snowball method (i.e., start with the account with the smallest balance) and you would pay $2,786 in interest and take 2 years to be debt-free. In other words, you would pay an additional $559 in interest and take a month more to be debt free than those who start with the highest-interest accounts.
Although the debt avalanche method is clearly the rational way to pay off debt, humans are not always that rational. A study by a team of Kellogg School researchers found that people with large credit card balances are more likely to pay down their entire debt when they follow the debt snowball method. As any casino manager will tell you, the lure of small wins is powerful.
Really, it doesn’t matter which method you use, as long as you stick with your payments until you are debt-free.
Step 4: Make more money
Increasing your monthly income will allow you to put more towards repaying your debt.
Get a side job
If you’re trying to get out of debt and have cut as many expenses as possible, it may be time to supplement your income. Thanks to today’s gig economy, it’s easier than ever to find “moonlighting” jobs that allow you to increase your income quickly.
If you want to earn some extra money pronto, consider one or more of the following side jobs.
Admit it. You have way too much junk. The average household has $1,000 to $2,000 of potential cash in stuff they no longer use. Empty that basement. Reclaim your garage. Get rid of that storage unit.
Step 5: Desperate measures to get out of debt
But what if your financial situation is so bad no amount of budgeting, consolidating, refinancing, or extra gigs will make a dent in your debt? In most cases, the tools mentioned above are enough for a determined person to get out of debt. However, there isn’t always a way to get out of debt without help. In such cases, there are two tools to consider: debt settlement and bankruptcy.
How does debt settlement work?
A debt settlement is an agreement between borrowers and lenders to make a lump-sum payment instead of the full amount owed. It is one of the most aggressive and effective debt resolution methods available. However, it is not a debt relief method you should take on lightly. Debt settlement will probably damage your credit score and force you to deal with debt collection agencies. It is a last-ditch resort that forces lenders to decide between forgiving a chunk of your debt or getting nothing at all.
Why would lenders consider forgiving part your debt?
The threat of bankruptcy is what brings many creditors to the table. Lenders know that personal bankruptcy can discharge unsecured debt and prefer to get something than to be left standing with worthless promissory notes. If you can convince your lenders you cannot afford to pay your debt in full, they may agree to a discounted payment instead. How much of a discount are lenders willing to give? It all depends on your negotiating skills and your financial situation. You should also be aware some of your creditors may refuse to work with the debt settlement company that you choose.
When should you consider a debt settlement?
There are no hard rules about when you can pursue debt settlement, but this is a useful guideline.
- Go to the list of debts you created before. Add all your unsecured loans.
- Pick up your cash flow budget and calculate how much disposable income you have after paying for bare necessities.
- Multiply your monthly disposable income by 60 (5 years).
- Divide the total by the total balance of your unsecured debt.
- Multiply the result by 100.
If the result is greater than 25%, you should probably not consider a debt settlement. If it’s lower, get a free consultation with a debt settlement expert and check your options.
Here are a couple of things to consider when looking for a debt settlement company.
Do they have minimum and maximum limits on the amount of debt you can enroll?
Most companies require you to have a minimum amount of debt, which is usually around $10,000. Some lenders, such as Freedom Debt Relief, accept lower amounts. Other companies also have a maximum amount of debt you can enroll, such as $100,000. You will need to find a company with requirements that match your needs.
What is their customer service like?
We typically don’t care about the customer service of a company until we run into problems or have questions. It is important to find out ahead of time about the level and quality of support provided by a company. You can do so by researching the support channels they offer (phone, email, live chat, etc.) and by reading reviews from past customers. Look for companies like Debtmerica Relief and Rescue One Financial, which are recommended by our community of users. Other debt settlement firms to consider are Pacific Debt and National Debt Relief.
This guide will help you decide whether debt settlement is a smart option for you.
How does bankruptcy work?
Bankruptcy is a legal process by which individuals and businesses can eliminate or repay debts under the protection of the federal bankruptcy court. There are two types of bankruptcies: liquidation and reorganization.
Chapter 7 is the classic liquidation bankruptcy. As its name implies, it requires debtors to liquidate or sell their property to pay some of their debt. However, some types of property are protected by state and federal bankruptcy laws. In certain cases, debtors may have little to pay once state exceptions (i.e., protected property) are applied.
Chapter 13 is the most common reorganization bankruptcy. With this type of bankruptcy, debtors get to keep all, or most, of their property. However, unsecured debt is not always discharged. Instead, it is reorganized into affordable payments. If a debtor completes the repayment plan (three to five years of monthly payments), pending unsecured debt is discharged. The catch is unsecured debt is generally not discharged until debtors complete the three to five years repayment plan. However, the completion rates of Chapter 13 bankruptcies are extremely low. Only a third of debtors complete the repayment plan.
This guide teaches you everything you need to know before you decide about bankruptcy before you make up your mind.
Getting out of debt guide for servicemembers
It is particularly important for members of the military to keep their finances in order because failing to do so could hurt their career. For instance, if you have a bad credit history, you could lose your security clearance or not qualify for a promotion (source). The unique challenges of military life can make it particularly difficult for servicemembers to manage their personal finances during their time in the service. Federal and state legislatures acknowledge this by providing special protections to active duty military members.
If you are an active-duty servicemember and you’re struggling with debt, follow the steps set out above. They apply to both servicemembers and civilians. However, you should also take into account the following laws before you make any important decisions. They provide special protections that could save you a lot of money.
The Servicemembers Civil Relief Act (SCRA) and debt
The SCRA offers extra protections to servicemembers facing financial difficulties during uniformed service. Here is a summary of the key protections included in the Servicemembers Civil Relief Act:
1: You can reduce the interest rate of any pre-service loan to a maximum of 6%
You just need to notify your lender in writing. Include a copy of your active duty service orders or a letter from your commanding officer with the date you start active duty service. If you qualify, this is an excellent opportunity to reduce your interest payments and focus on paying off your debt while you’re away.
2: Servicemembers receive additional protections against default judgments in civil cases
For example, if you are being sued in a civil action, courts can issue a default judgment against you if you fail to appear. If you are an active-duty servicemember, courts cannot issue a default judgment before it appoints an attorney to represent you.
3: Protection from foreclosure
Servicemembers cannot be foreclosed without a court order, as long as they took out the mortgage before entering active duty service. Upon request from the servicemember, courts are required to pause or stay a foreclosure if the active duty service is affecting the homeowner’s ability to pay the mortgage.
4: SCRA prohibits creditors from repossessing your personal property
This protection would prevent lenders from repossessing the property, such as a car, a boat, or a TV if it was purchased or leased before entering active duty service. The protection also applies if the servicemember made a deposit or installment payment on the item before leaving for active service.
5: Servicemembers have the right to terminate residential and vehicle leases without penalty
If you receive deployment orders or a Permanent Change of Station (PCS) for at least 90 days, you can terminate a housing lease without penalty. If the deployment is for longer than 180 days, you may also be able to terminate a vehicle lease without penalty.
The Miltary Lending Act and your debt
The MLA is a federal law that provides special financial protection to borrowers who are active-duty servicemembers (source). These protections include:
A 36% interest cap
The Military Lending Act sets a maximum Military Annual Percentage Rate of 36%. The MAPR is similar to a regular annual percentage rate but with more restrictions on the fees that must be included in the rate. This cap applies to most loans, including payday loans, tax refund loans, auto title loans, unsecured personal loans, and lines of credit
No mandatory allotments
Lenders cannot require a servicemember to set up a voluntary military allotment to pay for a loan.
No prepayment penalty fees
Creditors cannot charge a penalty for paying a loan or part of the loan early.
No mandatory waivers of legal rights
Lenders cannot require borrowers to accept mandatory arbitration or give up their Servicemembers Civil Relief Act protections.
To get out of debt is only the beginning. Once you’re free of debt, it’s time to save and invest in your future. If you’re like most people, the final goal is to be financially independent and retire early.
Read our investment guide and start working toward financial independence today.