Are you looking to level up your finances in 2023? You may want to consider reducing your debt. The first step in debt payoff is to understand your situation.
There are several ways you can reduce debt. We’ve gathered four common strategies to help you get started.
What are Minimum Payments?
Lenders will generally set a required minimum payment on your debt. These factors are speciﬁcally determined by the lender. If you can’t make the required minimum payment, you will face penalties such as higher interest rates and default (meaning you are unable to make interest or principal repayments).
Meeting your minimum payment works, but it may take longer to pay off your debt. Which means you’ll have to pay more interest over the life of the loan.
You can find your current monthly minimum payment on your credit card statement. Review the terms in your credit-card contract if you want to know how the minimum payment is calculated each month. These terms can change over time.
The minimum payment for a credit card is often higher than a minimum percentage multiplied by the balance (plus interest, sometimes) or a fixed minimum amount (like $15).
For instance, if your credit card balance is $2,000 with an interest rate of 18%, a minimum of 2% plus interest, and a minimum of $15. The required minimum payment would be $70. [Greater of ($2,000 X 2%) + ($2,000 X (18% ÷ 12)) or $15].
If you wanted to only make the minimum payments (recalculated each month), you’d pay off the debt in 114 months, almost 10 years. You would pay a total of $1,314 in interest. If you have a consumer loan, the minimum payment is usually the same as your regular monthly payment.
The Power of Making Extra Payments
Now, we know 10 years is a long time, so making additional payments to your regular or minimum payment can shorten that time. Making additional payments can also reduce the total interest paid. You can make additional payments at your own pace, whether it’s monthly, quarterly, or annually.
Using the $70 minimum payment example, if you pay an extra $30 to reach a total of $100 monthly payments, you’d pay off your debt in 24 months with a total interest of $396.
Here’s another example. If your current mortgage balance is $300,000 with an interest of 5%, a monthly payment of $2,372, and a remaining term of 15 years. Making regular payments would add up to a total of $127,029 in interest. If you pay an additional $400 a month, you’ll pay off your mortgage in 12 years and one month, and you’ll only be paying $99,675 in interest.
Crush Your High-Interest Debt First
Another way to improve debt payment is to pay the minimum payment for some debts and use any extra money to pay off debt with higher interest rates.
If you have two debts of $10,000 each with monthly payments of $200, the interest rate for one debt is 8%; the interest rate for the other is 18%. Making the regular payment of $400 will take 94 months to pay off both debts. You will also have paid a total of $10,827 in interest.
If you make instead make monthly payments of $600, allocating an extra $200 to the 18% interest rate first, you will pay off your debt in 41 months. You will also have only paid $4,457 in interest.
If you have multiple debts with high interest, you may be able to pay them off with a debt consolidation loan. Usually, this will be a home equity loan with a lower interest rate than the rates on the debts being consolidated. (Note that a federal income tax deduction is not currently allowed for interest on home-equity debt unless it is used to make significant enhancements to your home.)
It is important that you understand that a home equity loan can put your home at risk because it serves as collateral. If you fail to repay, the lender could foreclose, and you may also have to pay closing costs and other charges associated with the loan.
All examples are hypothetical and used for illustrative purposes only and do not represent any specific investments or products. Fixed interest rates and payment terms are shown, but actual interest rates and payment terms may change over time. Actual results will vary.