In personal finance, just like swimming, the more drag you have, the harder it is to be successful. When you pile on and mismanage debt, you’ll find yourself kicking harder and harder to reach full financial confidence. Learning more about debt and how to manage it will help you now and in the future.

What is debt

Debt is simply defined as a financial obligation.
So, how can something so simple cause so many big problems for people? Because they misuse debt, don’t borrow with good terms, and don’t pay it back on time – or at all.

But for most people, some debt is necessary to achieve their financial goals. That’s why it’s important to understand all you can about debt, such as the difference between good debt and bad debt, how to responsibly take on debt, how to maintain a strong debt-to-income ratio, and how to pay down your debt without paying too much interest.

 

Cost of debt

Debt, especially high-interest debt, can damage even the most solid financial strategy. For example, if you pay only the minimum payment of $61 per month on a $4,000 credit card balance that has an interest rate of 18%, it will take 23 years and 1 month to pay off the balance. You’ll also pay an additional $12,842.62 in interest on top of the $4,000 you owe.

That new pair of jeans you just bought on sale for $49 can end up costing you hundreds of dollars if you charge them on a high-interest credit card and pay only the minimum payment due each month.

jeans

Revolving debt vs. installment debt

How you pay your debt has two main forms, revolving and installment.

REVOLVING DEBT

Revolving debt allows you to borrow money against a set credit limit as you need it. Your credit card is the best example of this. This kind of debt must be closely monitored, as it’s possible to add to the debt over time and let it grow larger than you might want.

INSTALLMENT DEBT

Installment debt is created when you borrow a fixed amount in one lump sum. Your mortgage or car payment are good examples of installment debt. It’s easier to plan around installment debt because you know exactly how much you will be paying over time and when the debt will be paid off.

Paying off debt vs. saving

One of the biggest dilemmas that people with debt face is whether to prioritize saving money or paying down debt. It’s encouraged to make sure you establish an emergency fund of three months’ salary for any unexpected expenses. After that, consider participating in any employer-sponsored retirement plan, such as a 401(k) or 403(b), especially if your employer offers a company match for a percentage of your contribution – that’s free money! Beyond covering your monthly expenses, it’s wise to apply any money left over toward paying down any debt, especially credit card debt.

Managing your credit score

If you have taken out any loan, have a credit card, financed a car or carry a mortgage on your home, you have a credit score. Your credit score is your own and provides a potential lender (and even an employer) with a snapshot of how responsible you’ve been with debt. It’s based on how you’re paying down your debt; limiting the amount of debt you have, based on your income; and assessing the total debt you actually have, making sure you aren’t over-extended.

Credit scores are calculated and reported by three credit bureaus, including Experian, TransUnion and Equifax. Each bureau has its own criteria and scoring system, but the three are usually within a similar range and vary by just a few points. Some lenders may not use the scores from these three bureaus, but rather use your FICO® score, which is essentially the same score and is calculated by a data company called Fair, Isaac, and Company (FICO).

creditrange

A score of 800 or above is considered excellent. Most credit scores fall between 600 and 750. Higher scores represent better credit decisions and can make creditors more confident that you will repay your future debts as agreed.

Debt-income ratio

Debt/Income = DTI% As mentioned above, your credit score can be affected by your debt-to-income ratio. A high ratio means that you are carrying too much debt for your income, thus lowering your credit score and causing concern for lenders. A low debt-to-income ratio can raise your credit score and make you more attractive to lenders.

An ideal debt-to-income ratio is 35% or below. A ratio between 36% and 49% will still be considered by most lenders. Any ratio 50% or higher raises red flags, and applications for loans or credit will most likely be turned down.

Pre-retirement debt

Pre-retirement debt is a serious financial issue, but with some planning and focus, you can pay off debt and achieve your goals for retirement.

This kind of debt can come in many forms. You may be financing your child’s college education or wedding while also trying to pay off your mortgage and plan some much-deserved travel. The years leading up to retirement are crucial for many reasons, but none more so than learning to manage your pre-retirement debt while planning out your post-retirement income.

Leveraging debt

Leveraging debt, or putting debt to work for you, is a mature and somewhat frightening concept for most people. When you leverage debt, you are taking out a loan or using credit to pay for something that will most likely provide you with returns that will not only allow you to pay down the debt, but can provide additional income or profits.

Some examples include financing your education to earn a degree that will result in more career income. Another example would be investing in real estate to either fix up a property and “flip” it for a profit or invest in a rental property that generates monthly income. A third example would be using debt to finance a business venture that will provide additional profits and income. When leveraging debt, always consult with a financial professional and your attorney to make sure leveraging debt is the right strategy for you.

Credit Inquiries

People in their 50s carry the highest average credit card balances and overall debt. Why? Because they applied for and took on too much debt in their 20s and 30s.

So, what does this have to do with credit inquires? Because the more times you apply for credit cards, loans or other types of financing, the greater the negative effect it will have on both your credit score and the interest rates you will be offered. Every time you submit an application to take on debt, that entity reports it to the credit bureaus. It signals to them that you are either desperate or you are moving towards a high debt-to-income ratio. They will either deny you credit or approve it with a very high interest rate. The lesson here is to limit how often you apply for loans or credit.

Debt payment strategies

If you suddenly find yourself with high credit card or loan balances and you’re struggling to pay down the balance, take a deep breath, and come up with a plan and a schedule.

Using the widely recommended “Snowball Method,” determine the order in which you want to pay off your debt, usually the accounts with the highest interest rates should be first. Then create a calendar showing how much you’ll pay on each debt each month. Once you’ve paid off an account, roll that payment into paying more on the next account with the highest interest rate.

Another method is the “Momentum Method” where you pay off the account with the lowest balance first while only paying the minimum payment due on the other accounts. Once you’ve paid off that debt with the lowest balance, roll that payment into the next account with the lowest balance.

Choose the payment method that is right for you.

If you do happen to have some money in savings beyond your emergency fund, or you earn a raise or bonus, consider applying as much as you can toward paying down your debt balance so you can lower your amount spent on interest payments.

Just remember to use good judgement when assuming any debt so that you don’t get yourself into trouble. Funding an education, buying a home, or purchasing reasonable and practical transportation is good debt and can help you build a strong credit score if you make on-time payments. Spending wildly and racking up charges on your credit card without regards to cost and not paying on time can cause balances to be unmanageable and result in a low credit score making it nearly impossible to get a low interest loan. When you manage your debt wisely, you’ll be well on your way to building a strong financial future.

RESOURCES

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