Too much debt is the number one enemy of achieving your financial goals.
Now, debt isn’t always bad — it helps people become homeowners, obtain a college degree, and start businesses. Many of us start out with a “just for emergencies” credit card that can be a lifesaver in true emergencies, provided we don’t let the balance grow out of control.
The problem arises when we either borrow too much money (even if it’s for good reasons) or we borrow money for the wrong reasons. A loan to go to college? That’s usually good. A loan for a new Playstation and 65-inch TV? Not good.
If you’re spending more than 25 percent of your monthly income paying off debt, it’s going to be difficult — if not impossible — to save money for emergencies, that dream vacation or retirement — your future self.
The dangers of too much debt
When debt becomes unmanageable, it threatens your financial security. Paying off debt will prevent you from becoming stressed about how little you earn in relation to the amount of the bills you have to pay. An indication of a financially healthy person is having money stashed away for emergencies, education, medical expenses, or retirement, plus enough wiggle room in the budget to be able to enjoy the fun things in life.
Unfortunately for many Americans, that financial health sounds like a pipe dream. According to research from the Federal Reserve Bank of New York, the total household debt nationwide in the third quarter of 2020 was about $14 trillion. Although mortgage debt took up the greatest chunk of that total (about $10 trillion), credit card debt also comprised a sizable slice (about $810 billion), this data shows.
A healthy debt-to-income ratio is no more than 25% to 33% of your pre-tax income, financial advisers say. Look at what you earn monthly before taxes. Ideally, you should allocate no more than one-quarter or one-third of that amount toward your debt payments. If your debt eats up more than that, then your debt is too high.
Aside from the emotional and physical stress this can cause, too much debt can limit your opportunities: from the size and type of housing or vehicle you can afford to how well you feed and clothe your family and how you spend your free time.
What’s more, if you can’t repay your debts, you could lose your home or your car, as well as find yourself facing legal action such as having your wages garnished or filing for bankruptcy.
Types of debt
If you’re worried about paying your bills on time, all debt can feel overwhelming. But the world of finance divides debt into categories based on the return on investment and the interest rate.
Interest is a fee that a lender charges you for borrowing its money, and the interest rate is essentially a calculation of the borrowed sum plus the interest charges accumulated over a certain period of time. Let’s look at some common forms of debt.
As we mentioned, credit agencies consider a mortgage “good” debt because it involves something that grows in value: your home equity. Mortgage interest rates tend to be fixed and low over a period of time. As of January 2021, the average rate for a 15-year fixed mortgage was 2.380%, with an annual percentage rate (APR) of 2.720%. The benchmark rate for a 30-year fixed mortgage was 2.910%, with an APR of 3.210%.
Mortgage interest, like some student loan interest, is tax-deductible, which helps offset the cost. A mortgage also is considered “secured debt” because it involves an asset as collateral. If you fail to repay a mortgage as agreed, a lender can foreclose on your loan and repossess the house.
A loan to start or expand a business by hiring more personnel or purchasing equipment generally is considered “good” debt, again because it’s attached to something that theoretically grows in value. If you use your business itself or any of the equipment or supplies purchased as collateral, that business loan becomes a secured debt as well.
U.S. households had about $1.6 trillion in student debt as of the third quarter of 2020. Chances are that if you know anyone who graduated from college, medical school, or law school in the past few years, they’re repaying a student loan with a substantial balance.
Federal and private lenders exist for student loans, with a variety of terms and rates. Because education is an investment toward future employment, credit agencies generally consider student loan debt to be a “good” debt as far as your finances, and some student loan interest is tax-deductible to ease the expense.
That said, a student loan also is an “unsecured debt” because it has no asset as collateral. While the government or a private lender can’t repossess your education if you fail to pay, they can pursue payment through a collections agency—leaving a scar on your credit report—and seek further remedy such as garnishing your wages.
Credit cards, auto loans, personal loans, and medical expenses fall under this category of “bad” debt, which is debt that has a high or variable interest rate and goes toward items that lose value.
While some of this debt is secured debt, such as an auto loan (with the vehicle as collateral), credit agencies do not view this type of debt as favorably on your credit report as a mortgage, a student loan, or a business loan. That’s because you have invested the debt in discretionary purchases or items that depreciate over time.
Many consumers find their finances underwater because of expensive and unsecured credit card debt. One reason this type of debt is so troublesome is because of reverse compound interest.
You might have heard of compound interest in terms of helping an investment or retirement fund grow over the years. Reverse compound interest comes into play when you make only the minimum payment on your credit cards.
In a nutshell, the interest accumulates, as certified financial planner Tony Isola explains on his blog. If you put a $10,000 vacation on your credit card, for example, it will take 20 years for you to pay that off at 20% interest if you only pay the minimum payment each month.
Reducing debt – the interest rate matters
If you want to get a handle on your finances and pay off debt, high-interest-rate debt has to go. A personal loan with an APR of 36%? Forget it. An auto loan lasting more than five years, tacking on reverse compound interest while the vehicle’s worth drops? Move it along.
Sometimes a debt arises that we can’t help but put on a credit card, such as medical tests or surgery. (One study from the Consumer Financial Protection Bureau notes that medical debts were the most common past-due bills for which debt collectors contacted consumers, followed by telecommunications bills and utilities.)
If you can transfer such debt to a low-interest-rate credit card or to a personal loan with a 3% or 5% interest rate, you can save on reverse compound interest while still putting a dent in the balance.
Believe it or not, low-interest debt can be a good thing. Many financial experts say that a secured debt with a low interest rate such as a mortgage is one debt where it’s safe to keep paying the minimum payment. Some mortgages have a penalty if you pay them off before the term of the loan. Plus, when weighed against other forms of debt, a mortgage is relatively inexpensive considering the asset you have in return.
Aggressive debt payoff priority
Regardless of whether financial experts would list some of your debt in the “good” column, you still may want to pay it off as swiftly as possible. But varying minimum payments, interest rates, and monthly household expenses can make that challenging.
One way to pay off debts is to transfer multiple old debts to a new lower interest rate using a personal loan or a balance transfer credit card. This way, you have one lump payment going toward a smattering of older debts at a lower APR.
But faster ways exist to make that mountain of debt into a manageable molehill. These include:
The avalanche method
The avalanche method prioritizes whatever debt has the highest interest rate. The theory behind this method is that once the highest interest rate is gone, your overall payoff time and interest drop dramatically, like an avalanche.
Here’s how to do it, according to financial expert Dave Ramsey:
- Make a list of all your debts with the current balance and APR for each.
- Order them from highest to lowest in terms of the APR.
- For the debt with the highest interest rate, pay the most you can manage above the minimum payment. Pay only the minimum payments on the other debts. So if you have a credit card balance of $20,000 with an APR of 20% and a student loan of $10,000 with an APR of 5%, pay the minimum on the loan until the credit card balance is gone.
The snowball method
With the snowball method, you prioritize eliminating your smallest debt first, regardless of the interest rate. Once that debt is gone, you take the money that you would have paid toward that debt and apply it to the next-highest debt until that one is paid off. Rolling over the money freed up from one debt to another builds momentum, like a snowball.
Ramsey prefers the snowball method because it’s more motivating and empowering. As he writes, “[I]t forces you to stay intentional about paying one bill at a time until you’re debt-free.” Here’s how to handle the snowball method:
- Make a list of your debts with the current balance, lowest to highest.
- Tackle the lowest balance first by paying whatever you can manage above the minimum payment. Pay the minimums on all other debts.
- Once you eliminate the lowest balance, apply the money that went toward that debt to the new lowest debt on your list.
- Repeat under you have paid off your debts.
When not to pay off debts early
Before you decide on which way to pay down your debt, you should know that there are occasions when financial experts advise against paying off debt early. We’ve already mentioned following an established payment plan on debts, such as a mortgage, that have a penalty for early payoff. Here are a few other instances for which experts advise waiting before paying down debt.
Before you set up an emergency fund
Forbes suggests not kicking your debt payoff plan into high gear until you’ve saved a minimum of about $1,500 to $2,000. This creates a safety net when something goes wrong, such as your car needing a hefty repair. Otherwise, you may be relying on your credit cards to bail you out when unexpected troubles arise—and at a higher interest rate, too. If you don’t have any money set aside for emergencies, you’ll be forced to charge that expense, adding to your debt instead of paying it off.
When interest rates are near 0% (adjusted for inflation)
Anything with a 0% APR would be last on your list if you followed the avalanche method of paying down debt. But even if that balance is lowest, the experts at American Heritage Credit Union suggest paying the minimum to keep that credit card or loan option open, especially if a large payment will strain your budget or prevent you from building an emergency fund.
An interest rate of 0% offers some peace of mind. If you do have to use this credit or loan account for an unexpected emergency, you can at least rest assured that you won’t rack up a huge amount of interest along with the balance.
When you can get better returns by investing
Whenever you consider investing money, you’ll want to determine what financial experts call your risk tolerance. This isn’t a way of assessing how nervy you are; rather, it’s your financial threshold for weathering the ups and downs of your investment choices. Your age, income, time until retirement, and other financial factors all contribute to your risk tolerance.
Suppose you’re in your fifties without a lot of disposable income, for instance. In that case, you’ll need to have more conservative (and less risky) investment choices than someone in their twenties or thirties with fewer financial obligations and more time until retirement.
Paying down debt can grant you more disposable income and more freedom to allocate money toward retirement. But if you have several years until you stop working, you could reap a return of 10% or more before taxes over time by investing in certain assets, such as equities, instead of targeting your debt with every dollar you have.