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How to Handle Debt: Strategies to Save You Money and Improve Your Credit

May 2nd, 2017 · No Comments · Debt Management

by Kristy Welsh

(Last Updated On: January 4, 2018)

How to Handle Debt: Strategies to Save You Money and Improve Your CreditIn an ideal world, we wouldn’t need to handle debt at all. That, however, is not a practical approach to financial planning for most of us. Sure, it’s possible to save up enough money to buy a car with cash, for example, but can you wait that long? And if you have dreams of owning a home, unless it’s a tiny one, financing it is pretty much unavoidable. What you can do, though, is only take on debt that is necessary in light of your goals and circumstances. Then be strategic in how you pay it off. Yes, it will cost you money in interest fees, but it will also help build your credit and fund your dreams.

1) Only carry debt that is unavoidable

Debt you might need

Some may be “bad” debt, meaning it gives you no return on your investment. Like an auto loan for a car you need for work, but that starts depreciating as soon as you drive it off the lot.

But some may be “good” debt, meaning its value increases over time. Like a student loan for a degree that helps you earn more money, a mortgage on a home that appreciates in value over the years, or a personal loan that helps you fund your company.

Either way, as long as you make your payments on time, these loans will help build your credit score. Payment history represents 35 percent of your FICO Score and is “extremely influential” on your VantageScore.

Debt you should avoid

Credit card debt:

  • Credit card interest rates are usually much higher than installment loans (e.g., auto loans, student loans, mortgages, personal loans). When you carry a lot of credit card debt, you’re throwing a lot of money away.
  • The more credit card debt you carry, the worse it is for your credit score. That’s because of something called the credit utilization ratio. Amounts owed represents 30 percent of your FICO Score and the percentage of credit limits used is “highly influential” on your VantageScore.

This is not to say you should never use credit cards, but that you should only charge as much as you can pay back every month. And even then, you only want to use between 10 and 30 percent of your available credit at a time. The only exception should be emergencies for which you do not have enough savings to cover with cash. (This is what a $1,000 emergency fund is intended to prevent; more on this later.)

Payday and title loan debt:

  • As high as credit card interest rates can be, that’s nothing compared to that of payday and title loans. “A typical two-week payday loan with a $15 per $100 fee equates to an annual percentage rate (APR) of almost 400 percent,” says the Consumer Financial Protection Bureau. “By comparison, APRs on credit cards can range from about 12 percent to about 30 percent.”
  • It’s easy to get caught up in a cycle of indebtedness, as some states allow payday and title loan lenders to “rollover” these loans, costing you far more than the original loan amount. Plus, in the case of a title loan, there may be an even higher price to pay – losing your car.

If you’re stuck in a tight spot and feel like a payday or title loan is your only option, keep looking.

Call your creditors and try to get on more affordable payment plans. If it’s your rent or utility bills you need to cover, call your landlord or the utility companies and see if you can work something out. Talk to family or friends about a personal loan to get you through. Sell something if you have to. Exhaust every possibility before taking on loans like these. You should never have to handle debt with such costly consequences.

2) Find the best terms

One of the best ways to handle debt is to find the best terms. But don’t just limit your search to interest rates. If it’s credit cards you’re comparing, remember to look at application fees, annual fees, late payment fees, etc. When it comes to installment loans, look at interest rates, of course, but always relative to how long you’ll be paying on the debt. A lower interest rate could end up costing you more than financing at a higher interest rate over a shorter period of time.

We recommend credit comparison sites BankrateNerdwallet, and Credit Karma to:

  • Apply for new credit (credit card, auto loan, personal loan, mortgage)
  • Refinance existing debt (auto loan, personal loan, mortgage)
  • Shop around for a balance transfer credit card

Student Loan Hero is a good source for finding new private student loans, and refinancing existing private and federal student loans. (Just be sure you understand the benefits you are giving up if you refinance your federal student loans).

And when it comes to getting better terms on existing debt, don’t overlook an obvious source – your existing creditors:

Taking these steps can help reduce debt and make your monthly payments more manageable – good for your bank account and your credit score.

3) Decide how you want to tackle outstanding debt

Your budget

One of the biggest mistakes you can make when trying to handle debt is to pay everything else first and use whatever is left over for your debt payoff goals. But the only way to make significant progress with your debt is to budget for it. Here’s how to create a budget with debt payoff in mind.

Budgeting and debt management apps can help, as can this debt payoff calculator for seeing just how long it will take to pay off your debts based on principal owed, interest, and monthly payments.

Type of debt

Should you pay off credit cards first, installment loans, or a little bit of both?

Starting with credit cards is a good idea for a few reasons:

  • Credit cards tend to have higher interest rates than installment loans; paying them off first will save you the most money.
  • Paying on installment loans is good for your credit. The longer your history of on-time payments, the better it is for your credit score. Plus, once an installment loan is paid off, it’s marked as closed, which doesn’t do as much to help your credit as an open account through which you are continuously demonstrating responsible credit behavior.
  • Mortgage and student loan interest is tax-deductible. That, of course, is not the case with credit card interest.

That said, if you’d rather prioritize installment loans first – or lump them in with credit card debt – that’s fine, too. Only you know what’s right for you. Just be sure to save mortgage and student loan debt for last, prioritizing higher-interest auto and personal loans first.

Payoff method

Once you decide which type of debt you want to tackle, it’s time to decide on a method:

  • Debt snowball – You put all your extra money toward the debt with the lowest balance while making minimum payments on everything else. Once that debt is paid, you move on to the next lowest balance. In this way, you’ll pay off more of your debts faster, which can be an effective motivator to keep you going.
  • Debt avalanche – You put all your extra money toward the debt with the highest interest rate while making minimum payments on everything else. Once that debt is paid, you move on to the next highest interest rate. In this way, you are saving the most money and all of your debts will be paid off sooner.
  • Debt snowflake – You put extra “found” money toward your debt payoff. This is money you have not already given a job in your budget (e.g., rebate checks, money in your change jar, money made from selling clothes or books online, side hustles). This approach can be effectively combined with either the debt snowball or avalanche methods.

Not sure which method to choose? Check out our more comprehensive pros and cons of the debt snowball and avalanche methods.

Old debt

If you have debts that have been charged off by the original creditor and sold to debt buyers, they’re doing major damage to your credit score, not to mention your stress level if you’re being hounded for the money.

One way or another, these old debts need to be addressed, an essential part of the credit repair process. But before you pay off debt that is no longer with the original creditor, follow these steps:

  • As soon as you receive notice from a collection agency trying to collect on a debt from you, request debt validation. (Just be sure you do so within 30 days of the collector’s first communication with you.) If they cannot prove the debt belongs to you – and that they have the right to collect it – they must cease collection and remove the negative listing from your credit reports.
  • If it’s too late to request debt validation, but you still disagree with the debt owed, try a credit dispute. Maybe you believe you already paid this debt off. Maybe you believe that you owe less than they are trying to collect. Or maybe you don’t recognize the debt at all. If there is anything at all about the debt you disagree with, dispute it.
  • If you agree with the amount owed and debt validation has been provided (if applicable), check the statute of limitations on debt in your state. Even if the debt is accurate, if the SOL has passed, then you are no longer legally obligated to pay the debt. In that case, send this letter to the collector.
  • If the statute of limitations has not run out, you agree with the debt, and debt validation has been provided (if applicable), try settling for less than you owe.
  • Whether the collector settles for less or not, do not agree to pay more than you know you can afford. Also, be sure to request that the listing be removed from your credit reports once the debt is paid as agreed.

Once you have exhausted every possibility on this list, you can incorporate old debt like this into your payoff plan.

4) Fund your savings

As good as it might feel to start tackling your debt right away, it will do little good if you’re forced to turn right around and go deeper into debt. The culprit? Emergency expenses – like unexpected medical bills, or car or home repairs – that you don’t have the cash to cover. And what if you lose your job? Without savings, it could mean charging up credit cards again or taking out a personal lean to get by.

There is a better way to handle debt relative to savings.

Before you start paying off debt, save a minimum of $1,000 to an emergency fund.

Once you have that, Dave Ramsey recommends using the debt snowball method to pay off all your debt except your mortgage and then to save 3 to 6 months living expenses.

Alternatively, you could save up $1,000, focus exclusively on credit card debt, and then save 3 to 6 months living expenses before moving on to installment loan debt.

If it makes you uncomfortable paying off credit card debt while having so little in savings, consider Bankrate’s example from Kevin Smith, executive vice president of wealth management for Smith, Mayer & Liddle, a wealth advisory group in York, Pennsylvania:

“Suppose you have $10,000 of savings earning 0% interest and $10,000 of credit card debt costing 10% interest. Your net worth is zero, since $10,000 of assets minus $10,000 of liabilities equals zero, Smith explains. Each month, your net worth erodes further as you accrue interest on your debt faster than you earn it on your savings. The annual interest cost of your credit card debt is $1,000.

“By immediately using the $10,000 in savings to pay off the $10,000 of debt, your net worth remains the same but you stop losing money, Smith says.”

Credit Sesame shares a similar example further illustrating how costly it is to save while still paying on high interest credit cards.

Worst case scenario, you lose your job and have to charge your credit cards up again to get by. Best case scenario, you keep your job and pay off your credit cards.

All of that said, the right thing to do depends on what feels right for you. What’s most important is having at least $1,000 in cash before you start funneling money into any debt payoff plan.

Troubleshooting debt management

You can do everything right to handle debt and still run into trouble. Here’s how to deal with some common setbacks:

  • Did you have to use your emergency fund? Divert your debt payoff money back to savings until it’s built back up again.
  • Did you lose income? Go back to your budget. If you can continue to pay off debt, great, but if you lost your job, then covering necessary expenses must be priority number one. For now, let your debt payoff goals go.
  • Are you having trouble staying motivated by the debt avalanche method? Try the debt snowball. It may cost you more in interest fees, and take longer to pay off all your debts, but it’s still an effective payoff strategy.

Every budget needs to be flexible, and the money you’ve earmarked for paying off debt is a part of that. But if your troubles seem insurmountable, credit counselors and debt management plans are out there. Unfortunately, scams are out there, too, and even legitimate programs can be expensive. Get tips from the FTC on choosing the right credit counseling organization and debt management plan for you.

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