MCU’s Tips for Strategically Paying Down Debt
Debt is nothing new to Americans. According to a 2017 study conducted by Nerd Wallet, the average household carrying credit card debt has a balance of $15,654 and households with any kind of debt owe $131,431 (including mortgages). While it may be common, the consequence of debt can be severe – causing stress, lowering credit scores and affecting careers.
1. Know the difference between “good debt” and “bad debt”.
If you’re feeling ready to successfully tackle your bills and eliminate debt, simply staying on top of monthly expenses may not be enough. Check out our tips below to get started today!
Not all debt is necessarily bad. Before you can make a plan to strategically eliminate your debt, you’ll need to understand what is considered good debt and what isn’t. A simple rule of thumb is to determine if the interest rates are low, whether your debt will increase your net worth or if this debt has future value. If the answer is no and you don’t have cash to pay for the debt quickly, it’s considered bad debt.
2. Prioritize your debts based on interest rates.
For example, a home mortgage is typically considered good debt. While it is a long-term loan (typically between 15-30 years), relatively low monthly payments will free up money for investments, living expenses and emergencies. In addition, a mortgage allows you to gain the asset of a home, which will likely increase in value, which will enhance your net worth and ideally cancel out the interest you’re paying over time.
Contrarily, bad debt carries high interest and the purchases made with it lose value quickly and can’t generate long-term income. For example, if you buy an expensive pair of jeans for $200 with your credit card, but can't pay the balance for several months or even years, you’ll only end up spending more money over time, potentially even after your purchase has been donated, damaged or misplaced.
As you begin to tackle your debt, avoid taking on any additional bad debt. As a rule of thumb, If you can't afford an expense and you don't need it, don't buy it.
Prioritizing debt repayment doesn’t mean paying off one bill at a time and ignoring the rest. It refers to taking on all of your bills and debts at once but identifying which debts should be paid off the fastest in order to save you the most money down the road.
3. Carefully read loan terms.
Debts that have higher interest rates cost more money, every dollar of debt owed costs more each month and will carry over if it goes unpaid. By focusing on paying these debts first, you’ll save the most money because the interest that's accruing on your accounts will decrease.
By this reasoning, high-interest revolving debt, such store cards and reward credit cards, should ideally be paid off in full within one payment cycle. Lower interest credit cards should usually be prioritized next. Once these debts are paid down, you can focus on fully eliminating long-term and low interest loans such as student loans, auto loans and mortgages.
As the old saying goes, the devil is in the details. Always take time to carefully read through and understand the details of the debts you are taking on.
4. Consider consolidation.
Carefully read through the terms of the introductory rates you’re receiving on new credit cards. This will help you create a plan for paying off these debts before a higher interest rate is applied. Otherwise, you can have a balance of hundreds or thousands of dollars that’s suddenly getting hit with a high interest rate that can be over twenty percent.
I addition to rate changes, it’s important to understand what will happen if you make extra payments or larger payments on certain loans. This is because in some unusual cases, a lender will actually penalize you for making early repayments.
You also need to be aware of how making extra payments may affect your loan. In most instances, your lender won’t adjust the cost of your monthly payments but they will reduce the length of your loan. This is good news because a shorter loan period means you’ll pay less interest.
Choosing to consolidate your debt won’t just make managing a pay schedule easier by combining multiple bills into a single low-interest monthly payment – it can save you a significant amount of money, as you’ll eliminate the high interest rates.
5. Use moderation.
One of the most popular ways to do this is to transfer the balances of several higher-rate credit cards to a card with lower fees and (ideally) a zero percent APR introductory rate and a lower, more favorable rate after that. Borrowers can take advantage of this grace period to take advantage of paying down the principle of their debt.
To learn more about how debt consolidation, check out our blog post here.
Allocating extra funds towards debt elimination is a good idea, but don’t forget your other goals. While the idea of being debt free may be an exciting one, a common mistake people often make is that they solely prioritize debt elimination before giving attention to other important financial priorities, such as creating a nest egg.
In creating a moderate and balanced financial plan, both debt elimination, savings and even investing can occur at the same time. For example, don’t let the prospect of paying your auto loan off sooner prevent you from allocating funds to a retirement account.