People end up in debt – and stay in debt – for many different reasons. For some, debt wasn’t a choice: maybe there was a medical emergency or a loss of income. Others simply chose debt: to pay for school or buy a home or car, for example.
Debt can can linger for a long time, tying up your income for years and years. To limit the effects of debt and to free up your money for your financial goals, you’ll need a plan to eliminate it. Here are three suggestions.
The 20% payment plan isn’t so much a specific method as it is a budget guideline. In this plan, 20% of your net income (income after taxes) goes towards debt (not including mortgage or rent). 10% is saved and the other 70% is used for the rest of your expenses. So if your net annual salary is $40,000, $8,000 ($667 a month) should be dedicated to paying off debt every year and $4,000 should be used to build a savings fund.
This assumes two things:
- The total of your minimum payments for your debts is less than 20% of your net income. If it’s more than that, obviously you’ll need to pay more than 20% of your net income just to avoid late fees.
- That you can afford to set aside 20% of your net salary to pay off your debt (and 10% for savings).
Before assuming you can’t afford that 20%, take an honest look at your budget (or create a budget if you don’t have one yet). Are there any expenses you can cut or any ways to increase your income so that you can put 20% towards your debt? This is critical: paying off debt early requires making payments beyond the minimums due each month. If you truly can’t afford the 20%, put as much money towards your debt as possible.
The debt snowball is a debt payment plan popularized by Dave Ramsey. You pay as much as you can afford on the debt with the smallest balance and pay just the minimum on the rest of your debts. Once you pay off your smallest debt, you roll (or snowball) the money for that payment into your payments for the debt that now has the smallest balance. This continues until all your debts are paid off.
Like the debt snowball, the debt avalanche focuses extra payments on one debt while paying the minimum on the rest. But instead of targeting the debt with the smallest balance, you target the debt with the highest interest. After the balance is paid, the money for that debt is rolled into your payments towards the remaining debt with the highest interest.
Which is best for you?
Each method has its own advantages: the 20% plan can help you budget and integrates a savings goal; the debt snowball will likely produce tangible results quicker; and the debt avalanche will save you the most money. So if you generally need more structure in your finances or need to build your savings fund, perhaps the 20% plan is best for you. If you need to see results to stay motivated, try the debt snowball. If saving money is motivation enough, then the debt avalanche is the way to go.
Ultimately, the debt payment plan that’s best for you is the one that you will follow through with to eliminate your debt.