Debt. Could anything be more American? If you search “Debt in America” on Google, you can guarantee about 500 billion search results in under a second. It’s safe to say that debt is commonplace in the states.
It’s guaranteed to be a hot-button issue in politics, customary for university students, and a fact of life for any homeowner. So how do you manage debt in all its different forms?
Whether you’ve gone into debt to get a higher education or have had to use your credit card due to recent job loss, there are methods to managing debt and coming out of it successfully.
Understanding Different Types of Debt
To better understand how to manage debt, it’s crucial to get a bit of background information on different types of debt. As a whole, consumer debt in the United States is around $28.43 trillion in total. According to CNBC, Americans started off 2021 with around $900 billion in credit card debt alone.
What’s important to take away from these huge numbers is that debt is alive as ever and isn’t going anywhere. With that being said, not all debts are created equal. There are forms of debt that are good, and others that are not so good.
Types of “Good Debt”
Good debt can be defined as a debt that has the ability to increase your net worth or improve your life in a significant way. Here are a couple of examples of what good debt looks like:
1. Mortgage Loans
Buying a home can improve your life immensely. It can provide you and your family with a stable living environment and be an asset with significant value that you can keep for the rest of your life. Unfortunately, most people in the states cannot pay for a house in cash all at once.
When you take out a loan for homeownership, the value of your home is directly tied to your net worth and is considered an asset that you own. In many ways, buying a home can be an excellent way to save money and boost your net worth.
Mortgage loans can be a good form of debt because they allow you to acquire an asset that will appreciate over time. When you apply for a mortgage loan, interest rates are relatively low compared to other forms of debt.
For what you get in return after paying off your mortgage loan, it is definitely worth it to buy a home. As long as you make the monthly payments, you will be able to gain equity in that asset over time and can sell for a profit after its value has gone up over time.
Having a mortgage loan can temporarily hurt your credit score, but once you’re able to prove your ability to pay it back your score will increase. In fact, it can give lenders more confidence that you are not a high-risk borrower if you are making monthly payments on time over a long period of time.
2. Student Loans
While student loans usually carry higher interest rates than mortgages, they are still relatively low interest in comparison to credit cards. They also have the added benefit of being money spent on the betterment of your future.
When you choose to take out a student loan, you are investing in the ability to get a better job in the future. You’re also signing up to gain more knowledge that can potentially help your finances in the long term.
If you’re investing in your education, it’s important to consider what field of study you’re getting into and how that can potentially lead to a future career. This can prove to be challenging for many people.
Typically speaking, degrees in computer science, engineering, finance, medicine, and law will always be highly sought after and in demand. On the other hand, performing arts, early childhood education, and human services degrees are known to be the lower-paying career fields.
Before you jump into thousands of dollars of student loans, make sure you feel confident in what you’d potentially like to do in the future. Take some time out to research different fields of study and job opportunities available post-graduation.
Types of “Bad Debt”
Now that you have an idea of what good debt looks like, it’s time to go over what not-so-good debt or bad debt is. In simple terms, bad debt is money borrowed that can seriously hurt your credit score and put you into a poor financial situation that can be difficult to dig out of. Here are some examples of bad debt:
1. Credit Card Debt
Credit cards in and of themselves are a form of debt. Credit card companies offer you lent money and ask that you pay it all back within a certain period of time if you want to avoid extra charges. Credit cards are a prime example of revolving credit.
It can be easy to get into a cycle where you spend too much on your credit card and do not take the steps necessary to pay the balance on the card. Each month that your balance is not paid off in full, you will receive interest charges. The longer you keep a balance on your credit card from month to month, the more interest you will have to pay.
Almost anything you would buy with your credit card will not bring you any long-term financial stability. Credit card debt does not increase your net worth or provide you with anything worthwhile. It only leads to stress and compounding interest.
It can be tempting to splurge on flashy expensive things, but if you’re planning on doing that with a credit card, and don’t have money to support those purchases, you are getting into bad debt.
2. Luxury Cars
Even if you can afford the monthly payments on an auto loan to pay for a luxury car, remember that your car will lose value as soon as you drive it off the lot. The value of a car can depreciate by up to 30% within the first year alone!
To avoid bad debt, you may want to take a measured approach in buying big-ticket items and resist the urge to overspend. A car is often considered to be an essential means of transportation to get to work. But this doesn’t necessarily mean that you should take on a high-interest rate loan to get the newest Mercedez Benz.
If you are in need of a car, buy one that is within your means with low-interest rate financing. The last thing you need to do is overspend on a depreciating asset that you can’t afford.
How Debt Affects Different Factors of Your Credit Score
Having gone over different types of debt, you may be wondering how all this debt impacts your credit score. In order to fully understand the ramifications of debt, your credit score needs to be broken down into different sections. Here are the five main factors that make up your credit score:
- Credit Utilization
- Payment History
- Length of Credit History
- Credit Mix
- New Credit
Debt affects each factor of your credit score differently. Here’s a simple breakdown to give you an idea of how your debt impacts each one.
Factor #1: Credit Utilization
This factor refers to the amount of credit you have used in comparison to the total amount of credit you have to your name. For example, if you have a credit card with a $5,000 limit and have a balance of $2,500, your credit utilization would be at 50%.
Ideally, you want your credit utilization to be under 30%. This demonstrates to lenders that you do not act impulsively and spend every dollar available on your credit card. If you have a lot of your credit card debt, your score will most likely tank due to poor credit utilization.
Loans and mortgages, on the other hand, do not affect this aspect of your credit score. So think twice before making huge purchases on your credit card.
Factor #2: Payment History
Payment History makes up 35% of your total FICO credit score. As you can probably guess, this factor refers to your payment history across all accounts.
Every time you make a late payment on your credit card or mortgage, the three credit reporting agencies (Experian, Equifax, and TransUnion) will most likely receive the news and it will decrease your credit score.
If you make all of your payments on time, you will see your score steadily rise. Lenders are able to see that you’re trustworthy and less of a risk when it comes to borrowing money.
Factor #3: Length of Credit History
If you have several credit cards and are thinking of closing some of them, you may want to think twice. The length of your credit history is an important factor that goes into your credit score.
Lenders like to see a long history of accounts you’ve had to gain some insight into your financial responsibility. If you have accounts open for more than seven years (like a mortgage or a credit card) and they have remained in good standing, this factor alone can greatly help your credit score.
If you close accounts, that history will be gone and may raise some red flags from lenders in the future.
Factor #4: Credit Mix
Although this factor only accounts for about 10% of your overall FICO credit score, different types of debt may help you immensely here. Credit mix refers to multiple types of credit being utilized. This can include credit cards, auto loans, mortgages, and other accounts.
To optimize this factor of your credit score, you want a good mix of installment loans and revolving credit. A good example of an installment loan would be a student loan. Each month you plan on paying a certain amount over a certain duration of time.
Credit cards are a prime example of revolving credit. Month after month, you will still have that line of credit available to you with no specific end date. So in this case, debt can be beneficial to your credit score as long as there’s some diversity there.
Factor #5: New Credit
This final factor of your credit score is the least influential, but definitely worth mentioning. Every time you apply for new credit such as a credit card or personal loan, that information will appear on your credit report.
If the lender whom you are seeking money from makes a hard inquiry on your credit report, there’s a good chance your score will decrease by a few points. Although it doesn’t seem like much, it’s still important to keep in mind when shopping around for a new credit card or loan. Be sure to only do so when you feel as if you need the loan or line of credit.
3 Questions to Ask Yourself Before Taking on More Debt
If you already have some form of debt and are thinking of taking on more debt, it’s important to ask yourself the right questions to ensure that it’s a positive financial decision. Taking on more debt can seem easy and harmless when in reality it may not always be the best decision.
Here are some questions to ask yourself before taking on more debt.
1. Is It Possible to Use Cash Instead?
Before taking out a personal loan for your honeymoon or getting a new credit card to buy a new couch, ask yourself this question. Depending on what you’re obtaining borrowed money for, it may be worthwhile to pass on certain purchases until you have the cash.
You may want to go on a fun vacation with friends, but once you get back and have to deal with interest payments and years of paying off a debt it may not feel so sweet. Whenever possible, practice restraint and plan ahead. Making purchases you can’t afford can wreak havoc on your finances over time, which is why it is critical to ask yourself if you can afford any given purchase using cash.
2. Will the Monthly Payments Be Affordable?
This question can oftentimes be underestimated. When you apply for an auto loan, mortgage, or even housing, you will be given a monthly payment amount. Try not to stretch yourself out too thin by taking on a payment that is higher than what you would like to pay. Life happens and there are always expenses that you may not plan on.
If you have monthly payments that you’re barely able to make each month, you may find yourself in a sticky situation if you have unexpected expenses that month. To combat this potential pitfall, create a monthly budget and stick to it. Map out where your money will go every month and allocate a certain percentage of your income to each expense.
Be sure to budget your monthly food, housing, insurance, entertainment, and personal spending costs. After you’ve done that, try to save at least 20 percent of your monthly income to go towards savings and investments.
3. Will the Purchase Last as Long as the Repayment Terms?
There are many purchases that can last a long time, but there are some that might not be able to outlast the amount of time it takes to pay them off. Take an older used car for example. Imagine taking out a high-interest loan on a 10-year-old car with over 100,000 miles for $5,000. This is definitely a purchase you should avoid.
Older cars have a high likelihood of breaking down and costing you even more money in repairs and maintenance. It is very probable that this purchase will not last as long as the 5-year loan you took out on it, making this a situation you should stay away from.
Always take into consideration the durability of an item, and whether or not it will outlast the repayment terms. If it has a high likelihood of not lasting as long as the loan duration, reconsider making that purchase.
Coming Up With a Plan to Pay Off Your Debt
Now it’s time to get into the nitty-gritty of managing debt. If you have multiple debts you’re trying desperately to get paid off, this section is especially for you. Oftentimes it can feel discouraging to manage several debts at once. Having to monitor several different accounts each month can be stressful and discouraging.
The best idea is to come up with a repayment method that works with your lifestyle to prioritize certain debts over others to get them paid off. Here are two methods to do that called the Snowball Method and Avalanche Method.
Snowball Method
The snowball method was coined by Dave Ramsey, an American radio show host and businessman. This method is a debt-reduction strategy that focuses on paying off your debts in order from smallest to largest. So every time you pay off a debt, you gain momentum and continue to knock out the debts one by one.
Once you pay off your first debt, you roll the minimum payment you were making on that debt to the next debt – thus gaining more and more momentum. Here is a step by step breakdown:
Step #1: Make a list of your debts from smallest to largest.
Step #2: Make the minimum payment on all accounts each month except for the smallest debt.
Step #3: For the smallest debt, make the highest payment that you’re able to.
Step #4: Repeat this process until all debts are paid.
By starting with the smallest amount, you will see quicker progress in your goals being actualized and it will encourage you to stay motivated in taking on your next challenge.
While this idea seems to make sense on the surface and could be a great way to drive you towards your goal, the downside to this method is that it may take longer to complete and will result in higher interest paid overtime.
Avalanche Method
The avalanche method is another popular debt-resolution strategy. Unlike the snowball method, it focuses on tackling the highest interest rate debt first. So if you have credit card debt with 26% APR, it would come before a loan with only 15% APR.
By taking this approach, you will most likely be saving money in the long run by eliminating the risk of paying more in compounding interest fees. Interest can grow exponentially if left unchecked, so it seems reasonable to use this more ambitious method if you’re looking to pay off debt quickly.
Here are the steps to this method:
Step #1: Make a list of all your debts in order of interest rates from highest to lowest.
Step #2: Make the minimum payments on all accounts other than the one with the highest interest rate.
Step #3: Pay as much as you can on the highest interest debt until it is settled.
Step #4: Repeat until all debts are eliminated.
A possible downside to this method is that you may not see the results you’re looking for as quickly as with the snowball method. It all depends on what motivates you; some are motivated by the sense of progress, and others are motivated purely by numbers.
No matter which debt strategy you choose to embrace, try to keep a positive mindset and be consistent. It’s also good to practice organization when it comes to managing debt. Whether it be a neat spreadsheet or drawn-out calendar, it helps to have something you can look at to track your progress. It can also prevent you from going further into debt if you know exactly where your money is at.
How to Deal With Old Debts
Do you have an old debt that seems to be haunting you? Well, you are not alone. Debts that are over several years old can be a bit harder to deal with. Oftentimes you may not even know about an old debt until debt collectors start contacting you.
When dealing with old debts, it helps to know the statute of limitations on your debt. The amount of years varies in each state, so it may be a good idea to refer to this state-by-state guide. It may also be helpful to get familiar with the Fair Debt Collections Practices Act (FDCPA). This act lays out the legalities when it comes to paying old debts and dealing with debt collectors.
After becoming familiar with some of the legislation regarding debt, there are a few simple steps to take before signing off on repaying an old debt plus the interest accumulated over several years.
Step 1: Validate the debt.
This process involves sending a debt validation letter to a collection agency. The letter asks the agency to provide you with proof that you owe the debt they’re trying to collect. If you skip this step, you may end up paying more than you need to or even pay off a debt that was never yours in the first place!
Step 2: Check the statute of limitations on debt in your state.
The statute of limitations on debt is an allotted period of time in which your creditors can sue you for not paying the debt. After this amount of time has passed, they can no longer take legal action against you. Your debt will still show up on your credit report, but you will not have to worry about getting into major legal trouble with your creditors.
Step 3: Consider a pay-for-delete agreement.
If the collector can validate your debt and that debt is beginning to affect your credit score, you might want to look into what is called a pay-for-delete agreement.
A pay-for-delete agreement is a letter written to the collection agency requesting the removal of the collection from your credit report. Collection accounts that show up on credit reports can be seen for up to seven years and can significantly affect your credit. If the collections agency agrees, they will remove the negative information from your credit report in exchange for a fully paid off balance.
Takeaway
Getting a handle on debt can feel like an impossible task. If you desire to get out of debt and get on the path to a better financial future, be patient and realistic with yourself. Rome wasn’t built in a day.
With that being said, it’s important to understand different types of debt and how they can impact your financial wellbeing. Some types of debt, like a mortgage or student loan, can improve your quality of life, while others do the opposite.
Once you gain some knowledge of your own situation, come up with a plan that works for you and stick with it. It may take some tough decisions and self-awareness, but can ultimately lead to a happier day-to-day life.
Once you’re debt-free, don’t forget to celebrate. You got this!
