Once you've established the need to eliminate your debts, the next step is to gather information and calculate the best way to reduce it. You'll need to make a choice as to how you'll best stay motivated, but the mechanics of both approaches are similar. A great way to begin is by calling your lenders to negotiate a lower rate; once you've done that, you're ready to begin.
Making it Easy: Online Calculators
If you're not mathematically inclined, use websites that provide free debt reduction calculators
Vertex 42 offers several free calculators. Try the "debt reduction snowball calculator." Written in an Excel spreadsheet, you'll enter the creditor name, interest rate, balance and minimum payment. You'll also assign a priority to each loan. The spreadsheet will show you how long the debts will take to pay given varying payment amounts and timelines. It will also show you how much you've paid in interest over the repayment period.
The "Avalanche"
There are two ways to calculate and compare interest savings. The method that will save you the most time and money is called the "debt avalanche." In the avalanche, your debt with the highest APR (annual percentage rate) is paid first. When that debt's paid off, the payment is added to your next highest-interest debt (hence, avalanche).
Imagine you have two credit card bills, each for $1,000. Card A has an annual interest rate of 22 percent; Card B costs 9 percent annually. Without making a single payment, after one year card A's interest totals $220, while card B only cost $90. Paying the higher 22 percent interest rate first saves roughly $130 over one year.
The "Snowball"
Most borrower's debts aren't quite that clear cut, however. The "debt snowball" addresses this reality by espousing the theory that paying the lowest balance debt first allows the borrower to feel success early. Quick payoffs mean that the "snowball effect" happens faster, because the old payment is applied to the new debt.
For example, imagine you have a personal loan of $30,000 with an APR of 14 percent. You also have a credit card bill that's $4,000, at a 9 percent APR. Obviously, it will take much longer to pay the $30,000 loan, even under an accelerated program. The "snowball" says that paying the $4,000 loan allows for early success, and the subsequent application of that monthly payment to the bigger loan.
An Alternative: Consolidating Debt
Only if you are extremely disciplined financially should you consider securing a debt consolidation loan, such as a home equity loan. The risks for default are huge, especially when you use your home as collateral. It's essential that the borrower not incur new debts while repaying the old.
Despite these risks, this strategy saves the most money of all, especially if you qualify for a low interest rate. For example, if you opt to pursue a cash-out refinance of your home, you can pay as little as 3 or 4 percent (as of April 2011) and pay your high interest debts in full. The focus then becomes paying down the consolidation loan as aggressively as you would have paid the higher-interest loans.
Qualifying is difficult. You must have a considerable amount of equity in your home. You must have excellent credit. You may also have to use a loan instead of a line of credit; in this scenario, your home lender will pay off the other debts directly.
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