Keeping your finances under control starts with getting out—and staying out—of debt. You can learn how to manage debt so it doesn’t manage you by looking at where your money is going and how to optimize your finances. Debt is an amount of money borrowed by one party from another which is used as a method of making large purchases that couldn’t be afforded under normal circumstances. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest. We can break down the types of debt into three categories: Secured and unsecured, fixed and variable interest, and fixed and variable payments.
Types of Debt
Secured Credit: Utilizes a form of collateral, like a house or car.
Unsecured Credit: Has no collateral, like credit cards or personal loans.
Fixed Interest Rate: The interest rate stays the same for the entire timeline of the loan, like a mortgage.
Variable Interest Rate: The interest rate may change over the life of the loan, like credit cards.
Installment Credit: The loan is set to be paid off by a certain date, like a mortgage or student loan.
Revolving Credit: There is no set date by when the debt must be repaid, like credit cards. When you have a credit card with a balance on it, the balance will change or fluctuate depending on how many charges are made with it throughout a specified time period.
Costs of Debt
Although debt can be beneficial in temporarily expanding your income, there are often costs that go along with credit debt. The first question to ask “Can I really afford it?” It goes above simply making the monthly payment. You need to consider other factors as well, such as opportunity costs. Opportunity costs involve what you will be giving up to make a particular purchase. Will taking on this debt hinder my ability to meet my other financial obligations? Will it prevent me from saving for my financial future?
Good Debt vs Bad Debt
In general, good debt is that which increases your net worth and/or helps you to generate value. Good debt allows you to manage your finances more effectively, to leverage your wealth, to buy things you need and to handle unforeseen emergencies. Examples of good debt can be taking out a mortgage, borrowing to save time and money, or investing to increase future earnings.
Bad debt is that which does not increase wealth and/or is used to purchase goods or services that have no lasting value. Buying luxuries you can’t afford or carrying debt with high interest rates can be examples of bad debt.
Signs You Need to Manage Your Debt
Your debt-to-income ration is more than 36%. A debt-to-income ratio takes the amount of your recurring monthly debt (such as your mortgage or auto loan) divided by your gross monthly income. When you’re thinking about the amount of debt that you have, it’s best to think about it in terms of this ratio rather than measuring it by a set dollar amount. Most lenders will consider you “overextended” when your debt-to-income ratio is more than 36%.
Credit card balances exceed 10% of income. If you earn $50,000, carrying more than $5,000 on a revolving credit card could hamper your ability to respond well to a financial crisis.
You don’t have an emergency fund. How much money are you putting into an emergency fund? If your answer is “nothing” then this is a warning sign of a debt problem. If all of your income is being put toward your loan and credit card payments as well as necessary expenses such as groceries, school, etc. then there is often not enough left for saving. But then what happens when your car battery dies or an unexpected medical expense creeps up? Putting aside three to six months of savings to take care of any emergencies is ideal. If this isn’t possible right away, however, set little goals. Try to put $500 away, then $1,000, and so on if you can.
You have no money set aside for retirement. If your money is locked up in making payments of credit purchases, what will you do when you reach retirement age? Building wealth for the future relies on your ability to dig yourself out of debt.
You’re living paycheck to paycheck. If you are noticing your money from your paycheck is not going as far as you would like, it’s time to evaluate your debt. You’re not alone and it is a difficult way to live. So let’s look at how to tackle your debt.
Tackling Your Debt
There are a handful of different strategies and theories about paying down debt. Some believe you should start with the lowest balance, pay it off, and then take whatever you were paying toward that and put it toward the next highest balance—the “snowball” strategy. Be sure to set short-term goals for yourself so you continue to see progress and don’t lose your momentum.
When you’re in debt, it can feel like a merry-go-round of work, get paid, blindly pay bills. Take a second to analyze your debt repayment. As you go through each bill, ask yourself how you can reduce it. For your cell phone bill, can you downgrade your plan to save money or switch to a more affordable provider? With online subscriptions, are they being automatically renewed? Do you need all of the services you’re subscribed to or can you cut some from the roster?
Are there ways to lower your interest rates? Call your credit card company and enquire. Another option is to transfer a portion of your high interest debt to a card with a lower interest rate.
Can you cut your spending? Review your receipts and find where you’re spending can be reduced, freeing up more funds to pay down your debt balances.
Columbia Credit Union, credit counselors, certified financial planners, accountants, and attorneys are all resources you can turn to if you are struggling to manage debt. Book a free appointment with a certified credit union financial coach at Columbia Credit Union to talk about your goals and how to achieve them.