“Good” and “Bad” debt
Firstly, not all debt is bad, and in fact it can be a useful financial tool. The difference between good and bad debt is whether the debt is worth getting yourself into; and whether it benefits you in the long term. If there is a specific reason for taking on the debt and a clear affordable plan to pay it back, it is more likely to be classed as good. For example, over the long term it is likely to be beneficial to take out a mortgage, student loan or invest in your business using a loan.
Bad debt typically decreases your net worth in the long term and includes taking on debt that you aren’t realistically able to pay back. For example, purchasing an expensive new car that you don’t need. New cars usually lose their value and if you couldn’t keep up the repayments you could end up having to sell the car and would still have the debt. This typically includes overdrafts, and credit card debt you don’t pay back every month.
This article focuses on how to get out of “bad” debt (e.g. credit card, overdraft).
Debt Repayment Methods
There are different methods you can use to help you pay off debt. There are pros and cons to each method, and you can pick which one would suit you best based on which one you would most likely stick to and would enable you to get out of debt the quickest.
For all methods you will need to create a budget and work out how much of your income you can put towards repaying your debt each month. This will include analysing your outgoings to see where you can make reductions to allow for greater debt repayments.
1. Debt Avalanche
Method:
List all your debts by interest rate from largest to smallest, regardless of the balance
Work out your budget to make minimum payments on all of them
With your remaining budget pay off the debt with the highest interest rate first
Once the one with the highest interest rate is paid off, then take the next highest and so on
For example: you have a 10k credit card with 18% interest, 1k overdraft with 15% interest and 5k car loan with 3% interest. You would make minimum payments on all three and then pay off the credit card debt first, then the overdraft and then the car loan.
Pros: You pay less interest overall, and you therefore pay off the debt quicker, particularly if you have a large amount of debt.
Cons: Requires discipline allocating money to pay off a specific debt, some individuals lose motivation and skip extra payments minimising its effectiveness. Assumes you can pay more than the minimum balance across all debts.
2. Debt Snowball
Method:
List out all your debts by balance from smallest to largest, regardless of interest rate
Work out your budget to make minimum payments on all of them
With your remaining budget pay off the debt with the smallest balance first
Once the smallest is paid off, then take the next smallest and so on
For example: you have a 10k credit card with 18% interest, 1k overdraft with 15% interest and 5k car loan with 3% interest. You would make minimum payments on all three and then pay off the overdraft first, then the car loan and then the credit card.
Pros: Motivating strategy to pay off debts as you reach a specific goal quicker, which provides gratification. It’s easy to implement and easier to stick to than the debt avalanche method.
Cons: Costs more money than debt avalanche method, and therefore could take longer to be debt free. Assumes you can pay more than the minimum balance across all debts.
3. Debt consolidation
Method:
Review the market for what personal loan you may be accepted for at what rate
Apply for the new loan
Use the new loan to pay off all existing debts
Pay off the one consolidated debt; making more than the minimum payments if allowed
Pros: Easy to keep track off one debt, one lender and to measure progress. The interest rate may be lower than some of your existing debt, for example it is often lower than credit card debt.
Cons: The interest rate on the new loan may be higher than some of your existing debt. You will need to follow the terms of the loan carefully or you could end up in further debt. Depending on your credit score you may not qualify for the loan.
These methods should not be used for mortgage repayments.
Other Tips:
Visualise your repayment by dividing your total debt into 100 payments. Create a 10 x 10 grid on paper where each square represents 1% of your debt and hang it up. Once you have paid off 1% colour in the square on your grid to mark your progress. Celebrate each square you have paid off.
Talk to your lender, they may be able to make an adjustment to the balance, repayment plan or interest.
If you have debt that has a 0% interest repayment period then it would be worth focussing on paying that back first to save money
If you have credit card debt you may be able to transfer the money to a balance transfer card that has 0% for a period of time and reduce your interest payments to save money. There is sometimes a balance transfer fee so you will need to do the calculations.
If you are paying off credit card debt, but also spending on that credit card it will make it difficult to pay off. Consider separating the two.
Don’t accumulate new debt, for example
Leave your credit cards at home
Only pay for items in cash
Block websites that you frequently spend on
Automate your finances e.g. set up payments to come out the day after payday
Don’t have autofill for your cards on your phone or computer
Where can you get help?
There are lots of organisations offering free help to individuals to get out of debt. These debt advisors will be able to assess your personal situation to consider the most effective route out of debt. They will:
Provide information on the different options available, depending on how serious your debt is, for example on a debt relief order, an individual voluntary arrangement or bankruptcy
Can help negotiate with lenders
Inform you of government benefits you may be entitled to. For the UK you can also use the website EntitledTo.
Inform you of government schemes that may help you, for example the UK’s Breathing Space (60 days where interest and charges on debts are frozen).
Inform you of organisations that may provide further assistance. In the UK the website Turn2us enables you to search for charities that may provide you with grants (which you don’t have to pay back).
A few UK organisations that can help:
Citizens Advice
National Debtline
StepChange Debt Charity
Debt Advice Foundation
Debt Support Trust
Business Debtline