With inflation still at decade highs, more Americans are struggling to manage their debt. According to consumer credit company Experian, less than 25% of Americans live debt free now, and loan firm Lendingtree concurs, reporting that as many as one in three have struggled to pay their bills in the last six months alone.
Debt causes many to feel shame and uncertainty, and if left unchecked, can significantly impede any plans for the future. However, debt doesn’t have to hang over your head. Learn to manage and eliminate your debt, and one day soon you’ll be able to save and build a future to rely on.
The multiple causes of debt
It pays to understand that there are two types of debt: good and bad. Much of the distinction between the two comes down to whether that debt helps to build your wealth or drain it.
Experian’s 2021 Consumer Credit Review divides consumer debt into several categories to evaluate changes over time: credit card and personal loan debt, auto loan and student loan debt, home equity line of credit (HELOC) debt and mortgage debt.
Consider how these categories can be both good and bad types of debt. Credit cards, used to build your credit and paid off monthly, can carry a good type of debt. But credit cards used to pay for luxuries and finance purchases you can’t easily pay off this month carry bad debt, draining your money instead of helping you.
While it’s easy to advise people to live within their means, the truth of the matter is people often don’t. Or circumstances in their lives change and so their ability to pay their bills suddenly drops.
Before tackling your debt, pinpoint the cause of it. Did you rack up a lot of credit card debt you couldn’t pay when the bill came due? Or are you drowning in thousands of dollars of student loans? Or, perhaps, did you buy a house that turned out to be not so affordable after all?
Understanding the source of your debt allows you to take control.
If debt is financing a lifestyle you can’t afford, it’s bad debt. Period. You’re buying products and experiences and a life that will keep you barely treading water until you exhaust yourself. Choose instead to use debt as leverage for a business, for an appreciating asset, and pay off your bad debt to position yourself for a brighter future.
Increase your income and slash expenses to pay debt
Much of the internet focuses on paying off your debt by reducing your expenses, and indeed, financial experts strongly recommend cutting out the unnecessary to help you escape the debt trap as fast as possible.
If the majority of your debt stems from less-than-necessary expenses, the fastest way to pay down your debt is to stop the bleeding first. If you can’t afford to pay for your luxury goods, dining habits, your fancy car or your very nice house, you have to end the vicious cycle first. Pare back where you can by setting a budget and following it.
If, on the other hand, you’ve already reduced your spending as much as you can, there’s no way to get around it: you’ll have to increase your income to pay off what you owe.
Again, this is easier said than done. Fortunately, though, the internet provides plenty of opportunities and ideas. You can go for an in-person part-time job, or you can try freelance side hustles to work from home.
Search for an opportunity and build your income, relegating that extra money to paying off your debt. Once your debt is paid off, you might find you’ve grown your side hustle into a real, blossoming business that further feeds your savings and builds your wealth.
Which debt do you pay off first?
So say you’ve either reduced your spending or begun earning extra. Now you have the funds to pay off your bad debt. But if you, like most Americans, carry multiple types of debt, how do you know which one to pay first?
Depending on how your debt is distributed, it might be helpful to consolidate your debt under one loan. But consolidating your debt means taking out another loan and using that loan to pay off all your other debts. Consolidation is only useful if the majority of your debt is high interest and your consolidation loan offers you a lower interest rate.
Simply put, the worst debt is debt that charges you high interest, and you’ll want to pay that off first.
Credit card and loan companies charge high interest rates on debt, hoping that consumers will not pay more than the minimum payment. It’s one of the ways they make money. That means a $1,000 balance on a credit card at 24% APR can jump to $1,211 after a single year, even if you pay the minimum $40 a month. That credit card company has just made over $200 because you didn’t pay off your balance.
Debt avalanche method
Frankly speaking, the debt avalanche method is the most efficient, cost-effective and fastest way to get out of debt compared to other debt-reduction strategies. It focuses on paying off your highest-interest debt – your costliest in terms of interest charged – as fast as possible.
With the debt avalanche method, you pay as much as possible toward your highest-interest debt while maintaining minimum payments on the rest. Once the highest-interest debt is paid off, you tackle the next highest, once more maintaining minimum payments on the rest. And so forth, until all your debt is paid off.
Some financial experts also recommend the debt snowball method, which focuses on paying down your smallest debt before moving onto bigger ones. The snowball method helps to build momentum as you pay off your debt, hopefully giving you a psychological boost to continue managing your finances over time. However, while it can make you feel better and less stressed to finally erase one debt, you’ll ultimately pay the price for that psych boost in more interest accumulating on your high-interest loans.
Can you save while paying off debt?
A common question is whether you can save while paying down your debt. It’s stressful enough stretching your budget every month to cover what you owe, but not having a safety cushion in case of emergencies can add to the stress.
So, yes: not only can you save while paying off debt, you should absolutely aim to do so!
Experts recommend building up an emergency fund as a first step, which under a basic 50-30-20 budget would equal roughly three months’ worth of your take-home pay. If that sounds like a lot, focus on saving at least $400 in an emergency fund.
Having a minimum emergency cushion is vital, even more so than paying off debt, so aim for that $400 threshold first. Without an emergency fund, if you did encounter any unexpected issues, you’d just circle back to using credit to pay for that expense, digging a deeper hole for yourself.
Save the minimum, then get started on your debt avalanche. And make sure to budget an appropriate amount of savings every month as you pay down your debt.
How to pay off debt
The average American owes $96,371, and the worst thing you can do is ignore it. Interest will accrue on those accounts and missed payments can lead to late fees and serious damage to your credit score.
Follow these four steps to get out of debt:
- List your debt to understand what you owe. Write down all your debts with balances, due dates, interest rates, minimum monthly payments and the company who services your debt.
- Review your budget. Subtract your bills from your income to see where you can save on spending. Put this amount toward your debt repayment every month. If you can’t save more, aim to increase your income by asking for a raise, changing jobs or adding a side hustle.
- Prioritize your debts. Order your list of debts by highest interest down to the lowest to determine which one needs to be paid off first. Follow the debt avalanche method to manage your debt quickly.
- Make a goal timeline. Based on your debt balance and payments, how long will it take until you’re debt-free? For example, if you carry an average $5,500 balance in credit card debt with a 16% APR, paying $500 a month means your balance should be cleared in 12 months.
Bottom line
Dealing with debt can be stressful, but it doesn’t have to be unmanageable. It’s important to pinpoint the source of your debts and take action to prevent it from swallowing up your chances for financial freedom. Increase your income, decrease your spending and pay off your highest-interest debt as soon as possible. With a logic-based approach and determination, you can escape the debt trap after all.
