How paying off debt too quickly can backfire
By Allie Johnson
March 7, 2016
You’ve had it with debt, and you want out now. Before you start putting every extra penny toward your balance, wait: It’s possible to pay off debt too quickly.
In fact, overly aggressive debt repayment could end up putting you even deeper in the hole, says Danna Jacobs, a founding partner of Legacy Care Wealth, a financial planning firm in Jersey City, New Jersey. For example, you might get excited and make a huge payment toward a credit card or student loan, then run short on cash to pay the electric bill or rent.
“Paying down debt is an incredible endeavor, but there’s a right and a wrong way to do it,” she says.
The downside of rapid debt repayment
A small number of people can repay debt very aggressively without running into problems, says Kit Yarrow, consumer psychologist and professor emeritus at Golden Gate University.
These consumers, who tend to have “all-or-nothing” mindsets, love the gratification of watching debt decrease quickly, says Yarrow, author of “Decoding the New Consumer Mind: How and Why We Shop and Buy.” They may have no problem swearing off dinners out or good wine until the debt is repaid. In fact, they love strict rules.
“But most people are not like that,” Yarrow says.
Instead, if you’re like many people, too-rapid debt repayment might cause you to:
- Feel deprived, then overspend — “A restrictive spending regimen can be fun at first when you’re starting fresh and you’re all inspired and you can see the goal,” Yarrow says. However, the routine can get old fast, she says. At that point, you might feel too restricted and start rationalizing spending, or even splurging. “Instead of just going out for pizza, it might be pizza and wine and ice cream for dessert,” she says. Eventually, that can lead to abandoning your big plans for debt repayment. “Some people will say, ‘Well, we blew it,’” she says.
“Paying down debt is an incredible endeavor, but there’s a right and a wrong way to do it.”
— Danna Jacobs,
a founding partner
of Legacy Care Wealth
- Get caught with no emergency fund — If you get too focused on debt repayment, you might fail to create an emergency fund or drain your existing fund to make payments on your debts, which is a bad idea, says Thomas Nitzsche, media relations manager for Clearpoint Credit Counseling Solutions. If the car breaks down or the heater goes out and you have no emergency fund, you could end up putting those expenses on credit, putting yourself even deeper in debt. “Once you’ve made a big payment, you can’t say, ‘I need that money back. My refrigerator just broke,’” Nitzsche says.
- Overdraw your checking account — If you put all your extra cash toward debt repayment so you have no cushion in your checking account, one little record-keeping mistake could put you in the red. If that happens, you can get hit with overdraft fees. Close to 70 percent of U.S. banks charge $35 to $38 per overdraft, according to an overdraft fact sheet from the nonprofit Pew Charitable Trusts. Even worse, one overdraft can lead to another and, in a worst-case scenario, you could end up owing hundreds of dollars in fees to your bank. “Bank fees add up really quickly and can be really detrimental to your overall progress,” Jacobs says.
But beware: Paying down debt too slowly isn’t a good idea either. As the little repayment box on your credit card statement shows, getting out of debt could take decades if you just pay the minimum due, Nitzsche says.
Paying down debt at the right pace for you
There’s no debt repayment pace that’s right for everyone, so create a plan that works with your budget. Here are four steps to pay down debt at a speed that’s not too fast and not too slow:
1. Go over your budget. Look at your monthly income and expenses, as well as your actual spending from the past two months, Jacobs suggests. Look for areas in your budget where you’re willing to cut back, such as walking to work and putting the $200 you spend on Uber rides toward debt, she says. Earmark some money in your budget to buy yourself treats and pay for occasional conveniences such as ordering takeout for dinner, Yarrow says. “You get to see your goals met, but you also get rewards along the way,” she says.
2. Shore up savings. Everyone should sock away three to six months’ worth of expenses in an emergency account, and it’s fine to stay on the lower end of that range while you’re paying down debt, Jacobs says. Stick most of that money in an account that’s not easily accessible, such as at a different bank. But put $1,000 in a savings account that’s linked to your main checking account for overdraft protection. “That can be your cushion,” she says.
3. Pick a debt repayment strategy. Decide on a strategy for tackling your debt. In most cases, it’s best to pay down the highest interest debt first, Jacobs says. If you doubt your ability to stay motivated, you could try the “snowball” approach, starting with the smallest debt to give yourself a quick win, she says. Then, as each small debt gets wiped off, apply those debt repayment funds to the next largest debt and so on.
4. Keep your eye on the prize. Once you know how much you can comfortably pay each month, plug your numbers into an online calculator or a debt pay-off app to calculate how long it will take until you’ve erased the debt. Mark your debt-free date on the calendar. “It’s sort of like training for a marathon,” Jacobs says. “Most people need to know, OK, November 6th (2016) is the New York City Marathon and that’s my goal,” she says. Keeping that end in sight can keep you in for the long haul and give you “incredible motivation,” Jacobs says.
And as you stay the course, remember: In debt repayment, just like in marathons, slow and steady may just win the race.