Financial Friday #162: Debt Reduction Key as Interest Rates Soar!

There are lots of reasons people fall into debt but only one way out — and it’s going to require a combination of planning, discipline, and persistence. With interest rates now soaring on many types of loans, there is no better time to map out an action plan to reduce your debt.

Start by gathering information about all of your debts — student loans, credit cards, lines of credit, car loans, mortgage, overdue bills — everything. Make a list of all the debts with the details of the amounts owed, interest rate, and minimum monthly payments. This will help you set goals, create a timeline, and prioritize your repayments.

Your first goal is to make sure everyone gets paid the minimum amount required to avoid your debts going into arrears. Overdue bills and missed payments are going to play havoc on your credit score and it can take a lot of time and effort to rebuild. Although minimum payments on a credit card balance will keep your credit score intact, they will barely make a scratch on the outstanding balance. A $1000 credit card balance at 20% will take well over 10 years to payback and incur another $1000 in interest if you only pay the minimum 3% payment.

The next step is to figure out how much more you can allocate from your current income for debt repayment. One common debt pitfall is to look at your situation and conclude that more income is the solution — and immediately start looking for ways to make extra money. While more income can obviously help you reduce debt, it shouldn’t be your first step.

The most important step is to create a realistic budget. Reducing the expense side of your monthly budget is going to free money to pay off debt much faster than pumping up your income on the top line. You need to identify areas where you can reduce expenses and channel those savings to your debt repayment fund. It’s critical to start accurately tracking your expenses and get the actual data on your spending, not just a guesstimate based on your feeling.

While you're working to pay down debt, discipline and commitment are the real keys to whether you succeed or fail. If your budgeting willpower is waning, put a temporary hold on your credit cards and focus on making cash or debit card purchases within your budget. It isn’t a problem to continue using your credit card (cash is pretty inconvenient for some transactions), just make sure you pay any new credit card charges right away.

When it comes to who to pay first, there are two commonly used strategies for prioritizing debts: the debt avalanche method and the debt snowball method. With the avalanche method, you focus on paying off the debt with the highest interest rate first while making minimum payments on other debts.

The snowball method involves paying off the smallest debts first, regardless of interest rates, and then moving on to larger debts. From a financial perspective, the avalanche method is the best way to pay off debt, especially if the interest rate differential is large. It makes no sense to pay off a small amount on a home equity loan at 6% if you have credit card debt at 20%!



For the vast majority of us, there isn’t anything more expensive than credit card debt, and this is where you should focus. If you have been making payments and your credit rating is not too bad, you may be eligible for a credit card balance transfer offer with a promotional 0% interest rate for a specific period.

Make sure you have a realistic plan and are disciplined before you sign up for any balance transfer options or credit card consolidation loans. They are a good option for managing credit card debt as they lower or defer the interest, but you need to stay on the payment schedule. If you have any investments (TFSA?), selling them to pay off credit card debts usually makes financial sense.

Paying off debt is a long-term commitment that requires discipline — there is no quick way out. Once you get started and see some progress, your mindset will begin to shift, and a huge weight will start to lift. Becoming debt-free or at least in a position where debt stress doesn’t consume your life will do as much for your mental health as it will for your financial health.

Resources:

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