I’ve talked about a couple important concepts, such as budgeting and investing, as well as the effects of certain economic indicators on the economy and the finances of individuals. I will now talk about debt management. Debt is typically seen as a negative, but it’s actually quite important and can even be beneficial if managed correctly. Whether it be for student loans, buying a house, or starting a company, debt is an integral part of life, but more often than not, individuals end up mismanaging debt, causing extreme financial stress. It’s essential to understand good debt vs. bad debt and how debt is a part of your financial strategy, because it’s key to building wealth over time. So let’s get started on some of the keys to debt and managing it efficiently.
Key 1
Before you even decide to take on debt, you should first decide how much debt you can afford. There are many different ways to do this, but one effective way is to calculate your debt-to-income ratio. This is calculated by taking all of your monthly debt payments and dividing it by your monthly income before tax. The result should be a percentage, and you can compare it to the below standard. This standard is by no means the perfect way lenders assess debt, but it’s one way to look at it:
(from https://www.ameriprise.com/financial-goals-priorities/personal-finance/effective-debt-management)
If you are purchasing a home, a good rule to keep in mind is the 28/36 rule. Based on this rule, households should not spend over 28% of their monthly income before tax on housing costs and 36% of their monthly income before tax on their total debt payments.
Key 2
Now that you understand how much debt you can take on, you need to understand the difference between good and bad debt. Good debt typically means debt with low interest that helps you further your financial goals. Student loans, mortgages, business loans, and real estate investing are some of the examples of good debt.
Bad debt is debt with high interest that is used for means that don’t necessarily further your financial goals or don’t appreciate over time. Buying furniture, clothing, and payday loans are some of the examples of bad debt. High interest debt can build up quickly and can cost you hundreds of dollars. It’s important to consider what you will be buying with the money you are loaned, because not all debt is created equal.
Key 3
Be wary of credit cards. They’re really convenient and nice to have, but there are high interest rates on credit card balances you don’t pay when they are due. To work around this, here are a few tips:
- Spend what you are sure you can pay off
- The 20% rule: make sure monthly charges are at 20% or less of your credit limit – helps keep your credit score good
- Always pay charges on time
Key 4
Know strategies that can help you pay off debt faster. Some strategies include loan consolidation, the avalanche method, and the snowball method.
Loan Consolidation
- You combine multiple debts into one loan which has a single monthly payment
- The monthly payment usually charges a lower interest rate
How to do it:
- Take out a consolidation loan or transfer balances to a credit card with low interest rates
The Avalanche Method
- You pay off all debts in order from highest to lowest interest rate, make minimum payments on all other debts
- It seems slow and progress can often be discouraging, but it can save several dollars in interest in the long run
This is an example of this strategy, in order from the first debt to be paid off to the last debt.
- $15,000 credit card debt at 20% interest with a minimum payment $250
- $5,000 loan at 10% interest with a minimum payment $50
- $10,000 car loan at 5% interest with a minimum payment $200
- $20,000 student loan at 3% interest; minimum payment $300
The Snowball Method
- You pay off all debts in order from smallest amount to largest amount (regardless of interest rate) and make minimum payments on all other debts
This is an example of this strategy, in order from the first debt to be paid off to the last debt.
- $5,000 loan at 10% interest with a minimum payment $50
- $10,000 car loan at 5% interest with a minimum payment $200
- $15,000 credit card debt at 20% interest with a minimum payment $250
- $20,000 student loan at 3% interest; minimum payment $300
Key 5
And one of the most important keys to debt management is how to avoid debt. This goes back to the previous concept of budgeting, because if you make a proper budget, save money well, and have a sufficient emergency fund, you won’t have to pay as much debt.
And that’s all for today! There is a lot to debt management, but this is just a snapshot of what the concept truly entails. Hopefully you also understand the relationships between various concepts of financial literacy. They aren’t mutually exclusive, rather they work together to ensure an individual has the best financial future they can possibly have. Until next time!
Source:
“Ameriprise Financial.” Ameriprise.com, 2024, http://www.ameriprise.com/financial-goals-priorities/personal-finance/effective-debt-management.
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