Evaluate Your Debts
How comfortable are you with your debt? If comfort for you means hiding unopened credit card statements in a drawer and pretending the debt doesn’t exist, then it’s time to change positions. Comfortable debt is having mostly “good” debt for things you absolutely need and feeling like you have the means to pay down all your other debt—or at least keep it in control.
Good Debt vs. Bad Debt
Debt can come in many shapes and sizes: from a four bedroom home next to the park to a sale at the mall. Needless to say, some debt is better than others.
- Good debt: Good debt generally accumulates when you really need things like a place to live, a car, a college education, or home repairs—all things that usually cost more than is feasible for most people to pay cash. Most of us can, and do, live with these debts, including home mortgages; car loans; and, when used appropriately, home equity loans or lines of credit.
- Bad debt: Using credit to pay for things you don’t need and can’t afford equals bad debt. Store or house credit cards, which may charge interest rates as high as 21 percent, will hurt the most, and a great sale could end up costing you more in interest than you saved in the first place.
Avoid Debt-elimination Pitfalls
If you’re motivated to pay off bad debt quickly, carefully weigh your options and avoid these pitfalls.
- Misused home equity loans or lines of credit: You can use the equity in your home to access cash at a lower interest rate than what you may be paying on credit cards or other debts; however, make sure you have a fail-proof plan for paying it back on time. Defaulting on this loan could cost you your home.
- 401(k) loans: It sounds good at first since you’re borrowing from yourself and paying yourself back. But, by taking out a loan from your 401(k) savings, you’ll lose out on tax-deferred compounding of the money you are borrowing, and you may find it difficult to continue making tax-deductible contributions. Even though you will be paying yourself back with interest, those payments use after-tax dollars, so it will cost you more to save less. Finally, if you quit or lose your job during the life of the loan, you’ll most likely have three months to pay back the entire borrowed amount; otherwise, you may have to pay income taxes and a 10 percent penalty on your withdrawal.
- Having no plan: When borrowing money to pay down high-interest debt like credit cards, you need a plan to avoid repeating the same troublesome spending habits. Create a new budget that accommodates monthly loan payments and gives you a realistic idea of what you can afford without accumulating more debt. If you’re still struggling to avoid new debt, it may be time to get help from a debt counseling service.
Manage Your Budget and Spending
Ask yourself these questions to see if you are getting the most out of what you have.
- Where is your money going? If an empty wallet and maxed-out credit cards at the end of the month have you asking where it all went, then commit to writing down every purchase you make for a month. Next, evaluate your purchases to see where you can cut back the next month. Try to eliminate unnecessary expenses and pay down existing debt more quickly.
- Are you paying off the right debts first? Check the interest rates on all your debts, especially credit cards. Make the minimum payment due on all your cards, debts and loans then put every extra penny you can toward the card with the highest interest rate. Once the high-interest debt is paid down, tackle the next highest, and so on. Good debts, like your home mortgage, usually have lower interest rates, so pay off other debt first.
- Are you paying the minimum amount due? If you are paying the minimum amount due on your credit card bills, your payments may barely cover the interest you owe. Avoid costly interest rates and pay off debt sooner by paying as much of your balance as possible.
- Are you ready for emergencies? Even the most well-balanced budget can get turned upside down when the unexpected happens. As a good rule, keep at least three months worth of living expenses in an emergency fund, six months is even better.
- Do you need help? If you are in over your head, the bravest thing you can do is ask for help. Consult with a reputable debt counseling agency that may be able to lower some of your interest rates and can help consolidate your debts and help you better manage your finances in the future. Watch out for less reputable agencies that charge excessive fees, offer too-good-to-be-true solutions, or put you under undue pressure.