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Wednesday, February 21, 2024

How to pay off debt

How to pay off debt

Key takeaways 

Carrying debt can be stressful – but remember, not all debt is bad debt. By making a realistic and efficient repayment plan, you can get out from under, and save and pay for what matters most.

01.29.2024

Debt is common: More than half of surveyed Americans (54%) say they carry debt, with a debt burden most common among Gen X (72%). Yet for many, a sense of financial happiness is rooted in living debt free (65%). 

Debt can take a toll on your financial situation, so it’s wise to create a plan for addressing it – but remember: Not all debt is created equal.  

Here we’ll discuss different types of debt, ways to pay it down and tips for determining if a new loan is worth the expense. 

Good debt vs. bad debt 

Good debt, such as a home mortgage, helps build your credit while getting you closer to a long-term goal. “Good debt” may help you earn more income, increase your net worth, improve your credit score, or better your life in a significant way. This kind of debt often includes: 

  • Real estate mortgage: Carrying a mortgage from your primary home is often considered a positive form of debt. (The same can sometimes be true of other real estate ventures.) Not only do you get to enjoy the peace that comes with owning a home of your own, but you also benefit from a variety of potential tax breaks that are exclusive to homeowners. It’s possible that when you choose to sell, you may do so at a profit, as these assets typically increase in value over time. If you invest in other forms of real estate, like rental properties or retail spaces, it’s possible that you will be able to make a profit on those investments. 
  • Student loan debt: With an advanced education, your earning potential is likely to increase, alongside various benefits from college networking. It can be helpful to work with a financial advisor to ensure you are not overleveraging yourself or loved ones. Important considerations include types of loans, in state vs. out of state institutions, and financial aid.  
  • Business loans: Many people are attracted to the idea of opening their own business so that they can work on their own terms. But many new business owners must take on some debt in order to get their business off the ground. This is often regarded as “good debt,” as it is an investment in your financial future and earning potential. 

Bad debt, on the other hand, is a liability taken on for the purchase of a depreciating asset, or an investment that won’t increase in value or help you make more income. Common examples include: 

  • Cars: In general, vehicles are considered depreciating assets, as they typically decrease in value once you drive it off the lot. If you take on a car loan, you may be subject to high interest rates and loans that drag on for years. Car loans also can be beneficial however since many manufacturers have incentives such as low rates so you can put your money to work elsewhere.  
  • Consumer goods: From designer clothes to fancy furniture to fine art – generally if you are going into debt to purchase these kinds of consumer goods, this would be considered “bad debt” because of a high interest rate. These purchases rarely increase your net worth and earning potential. 

Read more: What is the average credit score? See how you compare 

What is debt management? 

Debt management is any system you use to pay off your debt and get your finances under control. The term debt management often refers to debt management programs offered by credit counseling organizations that help borrowers approach their debt in a more manageable way. 

Whether you DIY your debt management plan or hire a credit counseling organization, debt management means having a plan in place to become debt-free in the future. This is a key part of financial planning that your advisor can assist with.  

Which debt should I pay off first?  

When you have debt, it can be challenging to determine the order of operations. 

Step 1 

The first step to paying off debt is making a budget so that you know your cash flow – how much money is coming in and going out every month – to determine how much you can put toward debt.  

Step 2 

Next, track down your balances and interest rates by logging onto each loan’s online platform.  

You can log this in a spreadsheet, a notebook, or link the accounts of your credit cards, student loans and other agencies to Empower’s free financial tools. This last option shows all your balances in one secure place. 

Now, organize your debt in two ways: First by interest rate, then by the current balance. 

Step 3 

Keep paying at least the minimum monthly payments for all of your loans. Meanwhile, choose the way you want to tackle your debt payoff. 

Let’s explore two methods: debt snowball and debt avalanche. 

Snowball method 

The debt snowball method goes for the psychological win by ordering your debts from smallest to largest – regardless of interest rates – and paying off the smallest debt first. Then, you move on to paying the next smallest debt and so on. The mental boost of getting rid of a debt is meant to motivate you. 

Avalanche method 

The debt avalanche method comes from a pure mathematical perspective: You rank your debts based on interest rate, chip away at the debt with the highest interest rate first and work your way down the list. 

The best method of all? Deciding which one makes you feel more empowered – and sticking to it. While there’s no magical button for debt elimination, persistence and patience will yield results. 

Note: While you are aggressively paying down debt, it’s very important to not go into more debt, especially more credit card debt. Be sure to set aside cash in an emergency fund to cover you in case of a rainy day. High interest debt should be focused on before savings unless you have employer benefits like a 401k match.  

Now let’s dive into two common types of debt: student loans and credit card debt. 

How to pay off student loans 

Overall, the average student loan borrower owes almost $30,000.1 If you’re struggling to pay off your loans, consider the following options: 

  • Government repayment plans: If you have federal student loans, income-based repayment plans offer an extended repayment period of up to 25 years, with monthly payments based on a percentage of your discretionary income. 
  • Consolidation: If you’re making multiple student loan payments every month, consolidating them can bring all of them under one roof with one fixed interest rate — potentially making it easier for you to stay on top of your payments. 
  • Refinancing: Refinancing can provide a simple way to lower your interest rate or monthly payments. But it also turns federal loans into private loans, making you ineligible for income-based repayment plans in the future. 

How to pay off credit card debt 

With high interest rates, credit card debt can be particularly difficult to leave behind. That may be an issue for the average American household with $6,365 in credit card debt.2 If your balance seems to grow every month, it’s time to plan. 

  • Start budgeting: Look at your monthly income and expenses and figure out where you are able to cut costs. That extra money can help you pay off your debt faster. 
  • Focus your payments: If you have balances on multiple credit cards, choose one and work to pay it down as quickly as possible. You can choose the avalanche method (focusing on the card with the highest interest rate) or the snowball method (paying off the card with the smallest balance to gain momentum). 
  • Stick with it: Once you pay off one card, take the money you would have dedicated to that bill and put it toward the next card on your list. 

How to use debt responsibly 

Responsible borrowing can allow you to explore exciting opportunities like higher education and home ownership, as well as an increased credit score through consumer spending. 

But irresponsible borrowing can result in late payments, high interest rates, a damaged credit score, defaulting on loans, and more – all of which can have a long-lasting negative impact on your financial position. 

Here are five tips for using debt responsibly. 

1. Consider taking on debt as an investment in your future. 

Ask yourself if the amount of debt that you are taking on will eventually result in a significant improvement in your life or opportunities. From home ownership to higher education, make sure you have thorough understanding of exactly how much you will be borrowing and how much your investment may appreciate in value over the years to determine if this is a worthwhile investment. 

2. Before you agree to taking on the debt, analyze interest rates, fees, and repayment terms. 

From student loan debt to car payments, this is an extremely common pain point, as lack of knowledge about personal debt can result in payments that were higher than anticipated or repayment terms that make it challenging to maintain a healthy borrowing practice. 

3. If you choose to use a credit card, pay off the balance in full every single month. 

This will not only keep you from racking up hefty interest fees, but it will also establish a healthy borrowing history that can increase your credit score and help improve your chances of getting approved for other loans down the line. 

Read more: How many credit cards do I need? 

4. Make your payments on time. 

Late payments can result in fees and a damaged credit score, which in turn can make you look like a risky borrower to lenders. Set up autopay on your loan payments and credit cards so you never have to worry about missing a payment. 

5. Don’t borrow more than you can afford. 

While most of us take out loans with the best of intentions, it’s easy to get carried away once we have been approved for a line of credit. 

From financing a luxury vehicle to excessive credit card charges to using student loans for anything other than school-related expenses, these behaviors can lead to racking up a debt balance that is difficult to pay off with your current income. 

The bottom line 

While paying down debt, keep these figures top of mind: 

  • 10%: Work on saving 10% of each paycheck with the intention of saving more as debt gets paid off. 
  • Match percentage: Contribute at least enough to your 401(k) or other employer-sponsored retirement account to get your full employer match. 
  • $1,000: Save a minimum of $1,000 in an emergency savings fund – and then work toward tucking away six month’s worth of expenses. 

Debt payoff can be costly and time-consuming. But managing your “good” debt and “bad” debt can put you in a position to save and spend more on what matters to you.

1 Forbes, “2023 Student Loan Debt Statistics: Average Student Loan Debt,” February 2023.  

2 The Ascent, “Average American Credit Card Debt in 2023,” November 2023.  

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Jeremiah Forrest, CFP®

Contributor

Jeremiah Forrest is a Senior Finacial Advisor at Empower. He is a CERTIFIED FINANCIAL PLANNER™ professional.

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