Paying down debt? Here are smart strategies

The coming decade may well be known as the age when Americans turned their backs on debt.

Certainly, people are saving more and borrowing less. But it will take a long time to shore up balance sheets. Household debt -- without counting mortgages -- is some $2.4 trillion. Mortgage debt is another $10.6 trillion. Perhaps most worrisome, total student loan debt surpassed total credit card debt for the first time in June -- $833 billion versus $827 billion, respectively -- according to Mark Kantrowitz, publisher of Finaid.org and Fastweb.com.

Workers will probably face years of slow economic and income growth. Wages are stagnant and it's hard to see much of a gain in store for most workers with the nation's broadest measure of unemployment at 17.1 percent in October.

That's why it's remarkable how much progress people are making. The savings rate is higher than it has been for the past 15 to 20 years. The number of credit card accounts is down more than 23 percent since the 2008 peak and debit cards (essentially an electronic checkbook) are more popular than credit cards. Household debt service has declined from nearly 14 percent of disposable income in the fall of 2007 to around 12.4 percent by the second half of 2010 -- the lowest level in a decade. The embrace of financial restraint runs deep on Main Street.

Little wonder a question I get all the time is "What's the best way to pay down debt?" Lots of people owe money on several credit cards. They probably have an auto loan, and maybe a home equity loan, too. The loans all carry different interest rates and the amount of each debt is different. They've created a budget, clamped down on spending and freed up some cash. Where should the extra money go first when it comes to eliminating debt? (I'm excluding the primary mortgage and student loans from this exercise. We're going after consumer debt.)

There are two basic techniques. The first method comes with names like debt roll-up, debt avalanche, and master repayment strategy. It's the math-savvy way to attack the problem. Here's the logic: Make a list of debts, putting the one with the highest interest rate first and the lowest rate last. Target extra savings at the highest rate debt first and pay the minimum on everything else. When the steepest rate debt is gone, go after the next highest rate debt, pay the minimum on the rest, and so on.

The other tactic is best known as the debt snowball. Once again, make a list. But this time start paying off the smallest debt first and end with the biggest debt. Forget the interest rate. Attack the smallest debt first and pay the minimum on the rest. This method is about harnessing emotions to stay the course. It's about getting some momentum from feeling good as the smallest debt is extinguished. Its leading proponent is well-known personal finance adviser Dave Ramsey.

So, math or emotion? You'll pay less interest -- perhaps a lot less -- following the math. But if you need rewards to go on a debt diet, by all means go after the smallest debt first.  Either way, you come out ahead.

Chris Farrell is economics editor for American Public Media's "Marketplace Money." Send questions to cfarrell@mpr.org.

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