Debt Reduction Strategies

Creating a Debt Reduction Strategy

If you have a significant amount of debt – whether from credit cards, a mortgage, an auto loan, student loans or otherwise – chances are you've thought about the best ways to reduce what you owe.

Maybe your debt has strained your credit scores and you need to work on improving them. Maybe you'd like to enhance your credit history before applying for a mortgage or borrowing money for a child's education. Whatever your reason for paying down debt, success starts with understanding your current financial situation and building a strategy to follow moving forward.

How much debt do you have, and what kind is it?

The amount you owe and the type of debt you carry will have an impact on your credit scores and credit reports from the three nationwide consumer reporting agencies (Equifax, Experian and TransUnion).

Debt is typically divided into “good debt” and “bad debt.” Historically, debt associated with a mortgage, a business or student loans has been considered good debt, because the money you spend on your housing, livelihood or education comes with the expectation that you're improving your financial outlook. Your home, for example, will likely appreciate in value over time, and a good education will give you the skills needed to move up the corporate ladder, thereby increasing your earning potential.

Bad debt, on the other hand, is generally considered any debt associated with purchases that won't improve your long-term value. This includes obvious items such as credit cards, personal loans and payday loans, but can also include your car loan, since new cars generally depreciate upon purchase.

When setting up a repayment plan, take stock of all your debts, calculate the total and separate them into good vs. bad. Also, pay attention to the interest rate on each existing line of credit. It's good practice to pay off bad debts with high interest rates first, because creditors are less skeptical of good debt remaining on your credit reports. Of course, you still need to make on-time payments toward the good kinds of debt, but a mortgage that allows you to write off your interest payments at tax time is not as detrimental to your overall credit health as, say, a balance on a high-interest credit card.

Short-term strategies

When you've taken stock of the debts you have and how they're viewed by lenders, you can start to formulate ways to pay down what you owe. Begin the process by making a budget and committing to living within your means. If, for example, your monthly income is $3,000, make sure your expenses, including what you'll use to pay down your debts, are less than that.

Now you can decide which debt you want to tackle first. If you're looking for an easy morale boost, you might start with a debt that you can eliminate quickly, such as a credit card with a low balance or the remainder of a small loan. Crossing a debt off your list can build your confidence and help the overall effort gain momentum. This strategy is commonly known as the snowball method.

Another approach is to list your debts according to interest rate, highest to lowest, and start at the top of the list — often called the avalanche method. By tackling your high-interest debts first, you will eliminate the ones that cost you the most each month.

For example, say you owe $500 on each of two credit cards. Card A has an interest rate of 14 percent, while Card B charges 21 percent. If you make monthly $100 payments to Card B (the one with a higher interest rate) while making minimum payments on Card A, you will end up paying $2,652 in principal and interest rather than $2,723 if you had paid them off in the reverse order.

Whichever strategy you choose, be sure to put any extra money — such as a bonus, tax refund or side-gig income — toward your debt payments.

Long-term strategies

When reducing debt and rebuilding damage done to your credit scores, long-term strategies are equally important. This is where debt consolidation, debt management plans, advisory services and other third-party assistance can come in handy.

You might begin by seeing if you qualify for a hardship debt management plan. Also known as a DMP, these formal agreements are made between the debtor, their creditor(s) and a credit counselor. The debtor agrees to make a single recurring payment (e.g., monthly) to the credit counselor, whose firm divides that payment among the creditors on an established schedule.

Credit card issuers sometimes offer concessions — such as reducing interest rates, modifying repayment terms or waiving late or over-limit fees — to debtors who enter into a DMP. Before taking this step, however, you should be aware that a DMP will not directly affect your credit scores, but it could make future borrowing more difficult because it tells creditors that you were unable to pay off your debt in full or on the agreed-upon date.

In addition to reducing your debt, short- and long-term plans will help you to avoid being turned over to a collection agency. Things like unresolved charge-offs (when a creditor writes off your debt after several months of nonpayment), collection accounts, or court judgments against you based on accounts that you didn't repay can hold you back from rebuilding your credit scores as quickly as you would like.

If you do end up in collections, it is important to know your rights. The Fair Debt Collection Practices Act is a federal law that spells out what collectors can and cannot do, and the Consumer Financial Protection Bureau has a great deal of information on its website about how the process works. You can also read more on the Federal Trade Commission's website.

How to reduce your debt

Getting out of debt is possible when you know what you owe and what you can do to repay it. If you’re ready to begin paying down your debt, start with these three steps.

Step one: Understand debt reduction strategies

There are two basic strategies that can help you reduce debt: the highest interest rate method and the snowball method.

Highest interest rate method

This approach focuses on your debts like credit card and student loan debts with the highest rate of interest. The goal is to pay off the highest interest rate debt as quickly as possible, because it’s costing you the most. While it may not feel like you’re making progress, this method will help you eliminate your costliest debts first—which can save you money in the long run.

Snowball method

This approach focuses on your smallest debt. The goal is to get rid it as soon as possible. You keep on making the minimum payments on all of your debts, and you put any extra funds you have toward paying off the smallest debt. This will help you pay it off sooner.

Once you’ve paid one smaller debt in full, dedicate that freed up money to the next smallest debt. This way, you create a “snowball” of payments as you eliminate each debt. Unlike the higher interest rate method, you’ll see progress quickly as you pay off smaller debts. However, you may end up paying more in the long run, as you won’t be focusing on the larger or more costly debts.

Step two: Create your debt reduction plan

Download our debt reduction worksheet to put together a strategy that’s right for you. To use the worksheet, you’ll need copies of your bills and interest payment information. If you’re motivated by saving the most money while still paying off your debts, the highest interest rate method might be the right choice for you. However, if you’re motivated by seeing progress quickly, then you may want to consider the snowball method. Choose the strategy that’s best for your situation and put it into action.

Step three: Organize your monthly bills

Understanding what you owe, and when, will help you manage your debt. You can use a bill calendar to keep all your information in one place as you tackle your debt. Use the bill calendar to see all your bills and plan when they’re due. Keeping track of your monthly expenses can help put you one step closer to reaching your goals.

Take control of your finances

The "Get a Handle on Debt" series gives you tools to manage your debt by budgeting smarter, paying your bills on time, tracking your spending, paying down existing debts, and earning extra income. You can also get money management strategies sent directly to your inbox by signing up for our "Get a Handle on Debt" boot camp.